It's now less than six months to go before the January 3, 2018, go-live date for the European Union's Markets in Financial Instruments Directive II (MiFID II), perhaps the most wide-ranging shake-up of the European trading landscape in a generation.
At its heart, MiFID II is aimed at improving investor protection and transparency, with the latter a key building block to achieving the former. MiFID II's main transparency initiatives are embodied in new requirements covering best execution, pre- and post-trade reporting, and the shift of OTC trading to lit venues.
Of course, technical compliance by the deadline is top priority for most, but as with other recent 'Big Regulation' initiatives, many firms recognise they will need to finesse their approaches later, especially as the broader impact of the regulation begins to take effect. As they design and implement their responses to MiFID II, which will have far-reaching effects on market structure, financial institutions need to keep in mind the impact on the business of trading itself.
MiFID II attempts to boost execution venue transparency by introducing new reporting requirements for existing venue types like Multilateral Trading Facilities (MTFs) and Systematic Internalisers (SIs) and it introduces a new classification of venue in the form of the Organised Trading Facility (OTF).
At the same time, it will force multilateral dark pools operated by brokers - known as broker crossing networks (BCNs) - to register as MTFs if they still want to match client orders multilaterally. However, MTFs are subject to rules on volume caps, and to exemptions for Large-in-Scale (LIS) and Volume-Weighted Average Price (VWAP) transactions, all of which require firms to understand the classification of the order type and algorithm they are using.
Together, these measures amount to significant change in the trading venue landscape, and firms will need to assess how they impact the way they operate. Moreover, financial institutions will have to address changes to the marketplace from innovation sparked as a consequence of these changes.
These innovations - some dating back to the first iteration of MiFID - have led to the emergence of new venues like SmartPool, for Large-in-Scale trading, and of conditional order types on existing venues like Bats Exchange and LSE Turquoise, allowing firms to expose subsets of their liquidity without commitment, while still qualifying as LIS. Another innovation has been auction-on-demand and periodic auction venues, run by operators like Equiduct and Aquis Exchange. These market types can keep liquidity away from volume caps, avoiding pre-trade transparency waivers, through the use of non-continuous order books.
Another consequence of MiFID II is the likely evolution of many liquidity providers into Systematic Internalisers (SIs). As SIs, these entities will be subject to share trading obligation rules as part of MiFID II's limits on the use of dark platforms. Unlike dark pools, SIs must post pre-trade quotes under MiFID II. This can be further muddied by the addition of an intermediary where required to protect the order originator's identity.
Unsurprisingly, these changes will affect how firms route their orders. SORs will need to take into account far more parameters than they do now, ranging from different routing cycles for RFQs, periodic auctions, LIS venue rules and more.
This changing environment places particular emphasis on the platforms used by firms to connect to liquidity sources. MiFID II may mark the end of the traditional demarcation between OMS and EMS platforms. The OMS has traditionally been used to keep track of orders, order status and progress in working an order.
Under MiFID I, with its equities-only focus, things were more straightforward: there was some degree of OMS/EMS integration, even if the client-side OMS was merely routing orders to external EMSs at broker destinations. The complexity of the emerging post-MiFID II execution venue landscape, however, calls less for a discrete system for sending orders to a destination and more for a platform that addresses work flow seamlessly without the need for multiple external applications.
Under MiFID II, the European trading landscape will be characterised by multiple markets, multiple order types, and a number of fungible instruments per underlying security. The systems that were once separate and provided a 'swivel chair' capability are quickly becoming integrated, blurring the lines between traditional OMS and EMS functionality.
To date, firms' preparations have involved creative innovations, as they grapple with the multi-faceted regulation, which stresses transparency and investor protection. A number of key aspects are dominating trading firms' attention:
- Transparency, in terms of pre- and post-trade reporting;
- Best execution and its implications for order and execution management systems, SORs and record-keeping;
- Algorithmic trading and monitoring;
- Instrument and client definition management;
- Time synchronisation and high frequency trading classification;
- Systematic internalisation;
- Risk compliance and checks.
These and other requirements introduced by MiFID II are impacting how firms operate after the January 3 deadline. Specific provisions - like the new volume caps and high-frequency trading (HFT) classification - as well as broader concepts like new venue types across all asset classes - will affect how firms approach macro issues like staffing and more micro issues like the operational requirements of the OMS and EMS platforms.
With under six months to go, it's time to focus on operational solutions that meet the key regulatory imperatives but, importantly, fit with the firm's overall approach to trading business in the new regulatory environment and market landscape.