MiFID II: Agreement Finally Reached, Implementation Challenges Ahead
Last week, after more than two years of legislative haggling, and amid intense industry lobbying, the European Union finally reached political agreement on MiFID II (Markets in Financial Instruments Directive). The wide-ranging legislative package — the bedrock of the EU’s single market in financial services — establishes rules for the structure of markets and the trading of financial instruments, and sets conduct of business standards over the provision of investment products and services. But despite the political agreement, the process is far from over. With various technical details still to be developed by regulators, many implementation challenges lie ahead.
The genesis of MiFID II was to bring greater transparency to all aspects of the financial markets and strengthen investor protection standards. This approach reflects a desire to address the deficiencies revealed by the financial crisis, such as the opacity in derivatives markets and the manifest weaknesses in business conduct standards that have led to inappropriate sales practices. Underlining his vision of across-the-board regulatory reform, EU Internal Market Commissioner Michel Barnier commented at a CFA Institute event last February that “no financial products, financial markets, or stakeholders will escape regulation.” Certainly, this vision has been realised in MiFID II.
Market Structure Rules
The market structure aspects of MiFID II were a source of contention throughout the reform process, with banks battling exchanges over rules for dark pools and off-exchange trading practices, and member states (such as the United Kingdom) seeking to protect their industries from any potential erosion of competitive advantages. The rules surrounding market structure and trading practices were mostly agreed in the “trilogue” negotiations late last year. These rules include pre- and post-trade transparency requirements for trading in non-equity markets such as bonds and derivatives (an augmentation of MiFID I, which only applied transparency rules to equity markets); the establishment of a new category of trading venue — the “organised trading facility” (OTF) — for the trading of bonds, derivatives, structured finance products, and emissions allowances (ostensibly seen as the EU’s analogue to the U.S. Swap Execution Facility (SEF)); and more restrictive rules over trade transparency in equity markets. Each of these areas raises difficulties with regard to implementation.
First, pre- and post-trade transparency in non-equity markets will require further calibration. Although the rules take some account of the liquidity characteristics of different financial instruments, it will be left to the European Securities and Markets Authority (ESMA) to develop much of the detail. For example, the MiFID text allows for volume masking of bond trades with transactions only identified as being above a given size, but ESMA must develop these thresholds. Other factors that should be taken into account when calibrating the trade transparency regime for bonds include the size of the trade relative to the issuance size, the level of recent trading in a given issue, and a system of thresholds for deferred publication of large trades.
Moreover, ESMA will also be tasked with drawing up the list of derivatives subject to the “trading obligation” (that is, those derivatives that are required to be traded on organised venues such as exchanges and OTFs). To meet this requirement, which stems from the G20 commitments, ESMA must determine which derivatives are clearing-eligible and sufficiently liquid.
Second, the rules specify that OTFs must be multilateral (i.e., facilitate the matching of multiple third-party buying and selling interests), with restrictions on the use of own capital by OTF operators such as broker-dealers. Many of the instruments to which OTFs are ascribed have historically relied on dealer capital or inventory for the provision of liquidity, thus it remains to be seen how the shift toward a multilateral market structure with dealer neutrality will function. At the same time, neutrality does remove any conflict of interest between the operator of the platform (i.e., the broker-dealer) and the client, thus ensuring orders are handled fairly.
The provisions surrounding pre-trade transparency in equity markets have garnered considerable attention. The original MiFID established a set of pre-trade transparency “waivers” that would allow operators to waive the obligation to display orders for trading systems satisfying one of the following criteria: (i) orders that are large in scale, (ii) reference price systems, (iii) systems that formalise negotiated transactions, and (iv) orders held in an order management facility (such as “iceberg” orders). Dark pools must operate within the parameters of these waivers. For example, a dark pool passively matching orders at the mid-point of the best bid and offer prices on the primary exchange could qualify under the reference price system waiver. Broker crossing systems that previously operated outside the regulatory perimeter will also be brought into the MiFID framework.
MiFID II retains the pre-trade transparency waivers, but controversially limits the use of the reference price waiver and negotiated transaction waiver according to a “double volume cap” mechanism. Under this mechanism, trading volume in a given stock on a given venue cannot exceed 4% of total volume on organised venues, and total trading under these waivers (across all venues) for a given stock cannot exceed 8%. The double volume cap poses several questions.
First, the thresholds are arbitrarily set and perhaps unnecessarily restrictive — the research of CFA Institute on dark pools suggests that while it is desirable to maintain a predominance of pre-trade transparent trading, dark trading at such low levels is not likely harmful. Second, it is unclear as to how this rule will be enforced, absent a centralised mechanism to accurately and reliably consolidate trade data across venues and thus calculate volumes under these waivers. Although MiFID II does address the area of trade reporting, establishing standards for trade publication and allowing for the emergence of consolidated tape providers (CTPs), it remains to be seen how effective this new regime will be, particularly given that post-trade reporting was a notable defect under MiFID I. There are also practical details over how ESMA will enforce the rule and how the switch to pre-trade transparency will be calibrated if the volume cap thresholds are exceeded.
More encouragingly, the rules will also require reference price systems to provide price improvement at the mid-point of the bid-offer spread, a requirement that should more fairly balance the benefits of off-exchange trading with the opportunity costs facing displayed liquidity providers. CFA Institute has supported price improvement rules in other markets, which have thus far been adopted in Canada and Australia.
Focus on High-Frequency Trading
MiFID II introduces new rules surrounding automated trading, including algorithmic and high-frequency trading. Specifically, firms engaged in these activities will have to notify regulators with details of their trading strategies, conduct testing of algorithms, and establish controls to reduce the propensity for errant algorithms to propagate shocks through the financial system. Broker-dealers providing direct electronic access to markets to HFT firms will also have to establish controls and pre-trade filters to mitigate risks, while exchanges will also have to put in place various procedures to mitigate system stress. From an investor’s standpoint, these measures are broadly welcome and should help to engender safer and more resilient financial markets.
Controversially, however, MiFID II also requires electronic trading firms pursuing automated market- making strategies (such as high-frequency traders) to provide liquidity on a continuous basis for a specified proportion of time during trading hours. How this requirement is calibrated will be key — given that today’s markets are critically dependent on the provision of HFT liquidity, care must be taken to avoid excessively onerous measures that could hamper liquidity. At the same time, other investors could stand to benefit from a more reliable supply of liquidity, or at least a reduction in “fleeting” liquidity often associated with HFT activity. Calibration must carefully balance these considerations.
ESMA will also be tasked with developing the implementation details for matters such as establishing consistent tick sizes and circuit breaker mechanisms across venues, as well as incorporating order-to-trade ratios in the setting of exchange fees (such that firms cancelling a high proportion of orders incur higher fees).
There are many more areas in which ESMA will be tasked with implementation challenges, including requirements for open access to market infrastructures such as clearinghouses (i.e., interoperability arrangements), and rules with regard to commodities trading including the establishment of position limits.
Impact on Investment Advisers
MiFID II introduces a number of new rules to strengthen investor protection standards and reduce conflicts of interest in the provision of investment advice. Firstly, independent advisers will be prohibited from receiving inducements (commissions and other benefits associated with the sale of investment products), although the ban on inducements does not extend to other advisory channels (such as banks or bancassurance).
However, a more significant development is the requirement for investment advisers to meet minimum standards of professional knowledge and competency, with ESMA being tasked to develop guidelines specifying criteria for the assessment of knowledge and competence. This provision is a crucial development as it should ensure higher standards of professionalism and integrity in the provision of investment advice — in and of itself a key investor protection measure irrespective of the framework governing inducements.
Other investor protection measures include handing product intervention powers to regulators to ban inappropriate products for retail investors, among other things.
As the dust settles on this landmark agreement, it is clear that with much detail yet to be determined, the job is not yet done. We should all pause for breath before the next wave of rulemaking begins.
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Photo credit: iStockphoto.com/FrankyDeMeyer