Thursday, August 10, 2017

MiFID 2: Do We Know the Real Impact?

MiFID 2 are trading-related rules in Europe, but will have impact on global activity and participants everywhere.
More than those from other industries, financial institutions (banks, broker/dealers, investment firms, etc.) are accustomed to addressing the burden of regulation and assessing the short- and long-term impact. Many, however, will pout about the detrimental effect on income in blogs, annual reports and earnings calls, but they adjust. And they invest in people, systems and data management to do whatever they can to comply.

Sometimes, too, they procrastinate in preparing for or adjusting to changing rules.  Or they aren't sure of the real impact until deadlines and target dates loom. Take MiFID. Or what's technically called MiFID II (say, "MIF-fid").  Amidst the rumblings of normal mid-summer trading and banking activity now come scattered howls from banks and trading firms who must comply with MiFID II before the next big deadline, January 1, 2018. 

As that deadline approaches, banks, broker/dealers, trading firms of all kinds (high-frequency traders, algorithmic traders, alternative trading systems, inter-dealer brokers, exchanges, clearing firms, etc.) and even small investment advisers have begun to emit a big, collective "uh-oh," as they've begun to realize the new rules written in Europe might present bigger-than-expected obstacles in day-to-day trading activities. 

What is MiFID II anyway?

Markets in Financial Instruments Directive, Part 2. (Part 1 was implemented in 2007.)

MiFID, in sum, is the European Union's version of securities and derivatives trading rules in the ways such rules are written in the U.S. by such regulators as the SEC, CFTC, and the Federal Reserve (and codified by such legislation as the Dodd-Frank Act). 

During and after the crisis, the European Commission (along with the European Securities and Markets Authority) rewrote trading rules with a primary goal of ensuring that markets would be liquid and transparent and that investors would be protected and treated fairly.  In the aftermath of the crisis, a second version was necessary. And as expected, trading and investment rules are not summarized in a short, easy-to-read Word document.

In 2017, moreover, trading, dealing, and investing are activities that are as global as ever. Financial institutions have a footprint in most banking, securities and derivatives markets around the world.  Investors today buy, sell or trade securities and derivatives wherever there are opportunities. Bankers, dealers, traders, and investors step across national boundaries to find the best price, the best rate, the best counterparty, the best arbitrage, and the best trading ideas.  Funds, capital, securities and claims flow at all hours to all places.

Regulators in the U.S., Japan, Europe, and the U.K. and elsewhere play catch-up swiftly to ensure markets are fair, losses (yes, they are inevitable) will be manageable, and the less-than-sophisticated or uninformed participants are not taken advantage of.

MiFID II applies to securities and derivatives activities, which implies trading, dealing, and investing--from the trillion-dollar institutions to the recent college graduate buying a mutual fund. Comb through the hundreds of pages of rules (Level 1, Level 2, Level 3). The goals are simple, the rules are frighteningly detailed and complex, and the potential impact on global markets is what is causing some institutions and market watchers to squirm out loud.

The basic goals are worth praising:  investor protection, pre-trade transparency (best price, best execution), post-trade transparency (price reporting), execution on approved exchanges and venues (favoring those within Europe), cost-efficient research, and awareness of what's being traded and with whom. 

But MiFID has tossed a few knuckle balls in the process. For example, if an investing firm wants to purchase shares of an equity security, then new regulation requires that its broker/dealer funnel the trade to the exchange or venue offering best execution (with low transaction cost) and best stock price (lowest share price), as long as the venue is within the EU or the trading counterparty is in a foreign market with rules and regulation similar to those outlined in MiFID (called "equivalence" in regulatory nomenclature). 

What if the foreign market, which trades the same security at the best price, doesn't have equivalent rules?  Within MiFID, investor protection supersedes best price or best execution.  What if the ineligible trading counterparty is a well-known dealer in the U.S.? In this scenario, it loses trading volume and, therefore, trading revenue.  Now multiply that by millions of shares daily. Lost flow, lost business.

In securities research, MiFID will require investors know the specific cost of research they get from broker/dealers (or sell-side firms).  Conventionally, investors (including individuals and asset managers) pay for research from the commissions they pay broker/dealers when they funnel trades to that firm. To protect investors, MiFID wants them understand the real cost of research they are receiving and pay for it directly. 

Sell-side firms must alter how they present and distribute research and expect to engage in pricing wars with each other. To date, firms seldom, if ever, separated out or disclosed publicly how they quantified the costs of investment research.  In 2018, they must do this for investors based in Europe or investors based elsewhere who transact with institutions based in Europe. 

MiFID II does its best to cover all aspects of securities and derivatives trading.  It addresses issues and risks of "dark pools"--where large institutions match buyers and sellers of securities in-house beyond public markets (at the request of both parties).  It doesn't outlaw such activity, but wants to limit its prominence and impact.  It wants to avert the possibility that for some stocks, most of the trading could occur in dark, non-transparent venues. Those who preside over such trading pools must register as "systematic internalizers" and report trading data and prices in ways they weren't required do so in the past.

High-frequency traders, that segment of trading firms that rationalizes trades with exquisite algorithms and quick-trigger technical prowess, will be tolerated, but MiFID will require they disclose their general trading strategies to permit market players to understand their roles.

MiFID understands how investing and trading occurs in an expansive global arena, but is forcing players in the arena outside of Europe to implement rules consistently with those in the EU.  Hence, there has been focus on "equivalence."  If two firms engage in interest-rate swap trading and if one operates or resides in Europe, where can the two parties clear and settle the trade? Bank regulation (Basel III) may require it be cleared and settled by an approved counterparty. MiFID regulation may require it be cleared at a venue with MiFID-approved rules.  Does that mean the traders must overlook settling the trade at the Chicago Mercantile Exchange, where costs and efficiencies could be more attractive?

Beyond the howls and whining, most large, active financial institutions (from banks to small dealers and registered advisers) are familiar with the post-crisis landscape:  They recognize what new regulation is trying to resolve, complain resolutely, critique sharply, and weigh the impact. They lobby for easing some line items in rules, hire the right personnel, and invest in systems and data accumulation. They make the proper disclosures, reorganize, procrastinate, reshape business models, adjust, and then proceed.

And then of course, they might wait for MiFID III, where they hope regulators will try to ease the burden and simplify.

Tracy Williams

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