Compliance Supplement: Learning lessons

You may well have unpleasant memories of the preparations for the Markets in Financial Instruments Directive (MiFID), introduced back in November 2007. But more than two years on, has it brought pleasure or pain to the financial markets and what lessons have been learnt, asks David Adams? The European Commission (EC) is currently undertaking a review of MiFID to try and find out

Backers of the new multilateral trading facility platforms (MTFs), which have bloomed promisingly and eroded the market share of longer-established incumbent exchanges, must think MiFID quite marvellous. Others may be more miffed about MiFID. But perhaps the most common reaction recently would be, to quote Bart Simpson, to say "Meh" to MiFID - that is, to express indifference. There have been more pressing issues to occupy the sector's attention during the last two years after all, and President's Obama's recent proposals that banks shouldn't be allowed to run hedge or private equity funds, or to make money from proprietary trading unrelated to serving customers - while yet to be defined - threaten to shake up the wholesale banking arena more than anything else. Yet MiFID has already altered the structure of European equity markets in a profound way and changed the technology that is deployed. No serious player can afford to ignore it.

The MiFID 2010 Review currently underway is a chance for the European Commission (EC) to see if the Directive is working as it was supposed to, and possibly to offer any amendments out for industry consultation. In June 2009 the Committee of European Securities Regulators (CESR) pre-empted things a little by publishing a report on the impact of MiFID on equity secondary markets. It expressed support for further regulation, its findings suggesting that although increased competition between trading venues had resulted in reduced execution costs, these gains had been offset by extra costs associated with the complexity of market fragmentation. There was also discontent among market participants over low levels of transparency, the elusive nature of 'best execution' and the lack of a level playing field for trading venues.

The principle aims of the Directive were to encourage cross-border European harmonisation, break existing exchange monopolies, and to increase transparency for market participants. There's no denying that there has been some progress on the monopolies front. Already by March of last year, for instance, two MTFs, Chi-X and Turquoise, were among the top eight European equity markets in trade volumes and turnover. Turquoise is now, of course, though in the process of being taken over by the London Stock Exchange, which perhaps proves that all revolutionaries eventually become part of the establishment.

"If you look at what [MiFID] was supposed to do - namely, increase competition between venues, pan-European transparency, and impose conduct of business obligations and harmonisation across Europe - it's done those things well," says Denzil Jenkins, director of regulation at Chi-X Europe. "In the UK we tended to have [good] arrangements in transparency and competition and we forget that that wasn't the case across the rest of Europe. Before MiFID, in certain markets there was no over the counter (OTC) reporting and no common conduct of business standards. We [as a growing MTF] are one of the success stories of MiFID and clearly would feel positive about it, but our trading participants and buy-side institutions, while they may gripe about certain things, also believe arrangements today are much better than before."

Best execution
The post-MFID improvements have, however, come at a price. For a start, it is difficult to be certain of achieving best execution, while commission structures remain tied to paying for research as well as execution services. "The MTFs have certainly notched up competition in the exchange space, so there's now a lot more active trading, tighter spreads, more dark pool activity (i.e. non-displayed trades) and lower pricing, but for many investors creating this world of many exchanges is almost futile, because they live in a world of bundled commission," says Richard Balarkas, CEO at Instinet, operator of global agency brokerages and the Chi-X trading systems. "For an investor to be able to make full use of what MiFID has provided the fund manager needs full transparency over how brokers route orders, select venues and do their order handling."

"Theoretically the investor has enormous choice," continues Balarkas, "but in reality there's still a significant number of fund managers who only pay on bundled commission. People are still trading on venues that are not actually showing the best available price. That's likely to come from the fact that brokers have limited connectivity, that smart routing is weak or has biases [smart for who might perhaps be a good question], all due to this fundamental conflict of interest that most brokers have not declared. My suspicion is that the MiFID Review is not looking at this," he adds. "I'm not sure why. It might be regulated as less of a structure issue and more of a competition issue."

Whether or not Balarkas' charges about brokerage practices ring true depends upon who you ask, but best execution definitely remains a slippery concept, and an area of concern. It supposedly covers the best overall package, including factors like latency or longer-term value, depending on the client's goals and circumstances. It might not actually always mean the best execution price. Market forces do however help to nullify this problem, claims Stephen O'Sullivan, a senior executive in the Accenture consultancy's capital markets practice. "Everyone is getting hung up on best execution, but you only have to prove you are complying with your own policy," he points out. "If your policy is unambitious and uncompetitive then you will lose business."

Transparency and dark pools
More pre-trade transparency and a consolidated tape would help in attempting to meet the holy grail of best execution, but market fragmentation makes both things difficult. So, some would argue, does the use of dark pools of liquidity, which allow matching of trades in large blocks without prices being revealed until after the completion of the trade. Seventy per cent of market participants see dark pools as problematic for price discovery, according to a survey carried out by the non-profit CFA Institute in December 2009, which represents investment professionals.

Concerns have also been raised over the risk of information leakage, while some investors find it difficult to access dark pools, meaning they create a two-tier trading world - not at all what MiFID was supposed to do. In September 2009, the EU Commissioner for internal markets and services, Charlie McCreevy, declared that the migration of trading to dark pools in unregulated OTC broker dealer venues "gives rise to questions
as to whether there are unfair commercial advantages for the operators of these venues and whether the trend undermines price discovery, market integrity and efficiency for the market as a whole".

In the US the Securities and Exchange Commission (SEC) has started to try and limit the use of dark pools. Might there be calls for similar moves in Europe? Dr Richard Reid, director of research at the International Centre for Financial Regulation (ICFR), is not so sure. "It may be the case that improving information, reporting and disclosure rules - perhaps under the auspices of MiFID - will be the way forward," he suggested in a recent research note.

If dark pools at least serve a potentially useful liquidity function, data fragmentation helps no-one and the lack of a consolidated tape exacerbates inequality in the market, because bigger players can invest in a more comprehensive mix of data feeds. "For the buy-side, some firms have the skills needed and the budget to buy the technology needed and some don't," says Tony Freeman, director of industry relations, EMEA, at the trade lifecycle specialists, Omgeo. "They have to not try to get best execution [themselves] but to give [the job] to a broker," he claims. "I don't think you can legally devolve responsibility for best execution, but you can give your orders to a third party better equipped to get it. It's just like the old agency broker model."

Peter Twist, CEO at execution and commission sharing platform IND-X, envisages the evolution of a service that could sweep through best prices and dark pools, but notes how difficult it would be to standardise or regulate it across all product sets.

Chris Pickles, former chair of the MiFID Joint Working Group and now back to his day job as head of marketing, for financial markets, at BT Global Services, is not sure that any single entity could ever fulfil such a role. "You can't solve data fragmentation," he says. "I don't think we need a department of the European Commission being a collector of financial data in real-time. We do need to find less expensive ways of gathering data. That has to come through standardisation." Others insist a quasi state-backed consolidated tape is the way to go.

There is also inconsistent interpretation of MiFID across the EU. "In Greece, Poland and Spain they don't necessarily know what MiFID is," says Luca Lancellotti, head of account management at vendors, the List Group. "It's a very different approach in the countries I see in southern Europe and
Eastern Europe."

Accenture's O'Sullivan says he always thought that improving passporting between EU countries would be one of the most difficult of all MiFID's aims. "In theory you can use any broker in any country as easily as in your own country," he recalls, "but it hasn't been as successful as was intended, and may be conflicting with a broader set of G20 issues that have arisen as a consequence of the financial crisis. There are competing priorities that the Commission itself is not [sure] how to resolve."

There are also issues connected to post-trade processes. "Many of the price reductions we have seen emerge are defeated by problems with clearing and settlement," says Instinet's Balarkas. "You'll get heavily penalised for completing an order across MTFs. It's time there was some imposition of efficiency on the back office." This is, of course, something that's been awaited for a considerable amount of time, with the Giovannini protocols, EU Code of Conduct and many other initiatives targeting the post-trade arena. It is something FST will return to again in our September-October10 edition this year (following on from previous coverage: see HERE).

How might the MiFID 2010 Review address all these problems? Balarkas hopes its recommendations will be more subtle than brutal. "I dread the idea that someone might say MTFs and dark pools can't operate
[understandable with his link to Chi-X]," he says. "Generally speaking [MiFID] was well thought-through, it just hasn't been implemented very well. It creates competition between exchanges, but depends on an objective definition of best execution, which is not plausible or possible. If I was writing the Review it would be a thin document and would look at what was originally stated in MiFID. I'd then seek to make sure that was what was happening first, rather than making further dramatic changes."

His is not the only voice calling for restraint. Richard Britton, senior consultant at the International Capital Market Association (ICMA), has expressed concern at a recommendation from the CESR for the EC to adopt a mandatory trade transparency regime for the corporate bond market. Britton's view is that this would have a similar effect on European markets as did the US TRACE regime on the other side of the Atlantic, benefitting retail investors through tightening spreads, but making executions slower and less predictable for larger institutional investors.

The EC is giving nothing away about the contents of the Review at the moment. But whatever its contents, everyone is speculating about what happens next? BT's Pickles is sure that the technological theme of the next few years will be standardisation. "The industry will be looking at how to take unnecessary cost out of the financial markets infrastructure," he says. "At the moment you have to have different software and hardware for every exchange you deal with. Some exchanges insist you buy their trading network. That has to change. Small investment banks and brokers have to be able to trade on any exchange. We have 2,000 firms in Europe who want this type of solution."

Finally, it is interesting to note the views of the London Stock Exchange on MiFID. "It has been a partial success.. it was intended to bring about more competition in markets and services [and] it has definitely done that," said a spokesperson to FST. "MiFID has also led to fragmentation of trading and arbitrage between platforms.. an inevitable consequence of the move to a competitive landscape.

"There are advantages to a competitive environment in terms of tighter prices and lower costs," the spokesperson continues. "Competitive pressure keeps all market participants on their toes. But MiFID is trying to solve a conflict wrapped in a contradiction: in theory the most efficient market is a single market without fragmentation of trading."

Even Chi-X's Jenkins has to admit that more work is needed to iron out these contradictions. "MiFID has some unfinished business, particularly around the issue of a consolidated tape," he concludes. "It was originally left to market forces, which haven't really delivered what was required. Also, best execution, an area fundamental to MiFID, hasn't delivered on its promise. But if we were to make great strides into those areas it would have a significant impact in improving the overall quality of the market."

Still, says Accenture's O'Sullivan, these are early days. "It's only two and a bit years into the MiFID story since its introduction in November 2007," he points out. "I think it has had quite a profound effect on how equity market traders operate and it will be seen as quite a groundbreaking initiative by the EC." But he too, advises caution: "They need to be careful about how they take it forward." Onward then, Review panel, but steady as she goes and learn the lessons as you go along to avoid too much pain in the future. Nobody wants a possible 'MiFID II' to be as time-consuming as the first one and hopefully any future amendments can be achieved more seamlessly.

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