More Bite? Europe Braces for MiFID II

MiFID II doesn’t exist—depending on who you ask, at least. Despite the fact that almost every segment of the European securities markets is getting ready for the next iteration of the EU’s 2007 Markets in Financial Instruments Directive (MiFID), any mention of this actually representing a clear-cut second generation of legislation is often met with a stern rebuttal—from regulatory bodies and resolutely diplomatic market participants alike.

The standard response is summed up by Alexandra Foster, head of sales with agency broker Instinet. “When I was in Brussels in December meeting with some of the European regulators, they were very keen to stress that this is a review of the first version, focused on picking up anything that was missed and changing any outcomes that weren’t anticipated,” she says. “They want this to be MiFID 1.1.”

But the current state of affairs is not without its critics, and when the Committee of European Securities Regulators (CESR) opened a five-week window for industry feedback on its plans to amend MiFID, market participants drew up comprehensive lists of areas they felt needed attention.

The directive has unquestionably transformed the European trading landscape since its November 2007 implementation, but questions remain over just how effective it has been in achieving its original aims—promoting competition and creating an open, fair and level playing field for all European investors. Moreover, markets have changed beyond recognition in a little over two years and in the wake of the financial crisis, regulatory targets have shifted drastically

Indeed, many feel that MiFID has fallen rather short of its goals, in some territories at least. “I’m unsure whether investors throughout Europe are being treated equally and fairly,” says Foster. “There are still some nations within the European group that have purported to sign up to MiFID, but both retail investors and certain institutional investors are really not getting the full advantages of best execution.”

Post-Trade Dilemma

Beyond geographical differences in implementation, the three areas for attention cited by almost all sections of the market—Foster included—are dark pools, high-frequency trading and post-trade processing.

The latter has been a thorny issue for some time thanks to a perceived lack of post-trade transparency, and disagreements over data costs, but a solution has yet to be proposed that receives industry-wide approbation. One must be reached, however, says SIX Swiss Exchange CEO Christian Katz, not least to improve detection of market abuse. “We feel it’s impossible to properly supervise the market without suitable post-trade transparency,” he says. “If, at the end of a trading day, you can’t tell where a given stock traded everywhere in Europe—at what prices and by whom—then how can you hope to supervise the market? We have to have a single set of eyes looking at the same data, because otherwise market manipulation or insider trading will be much harder to detect.”

He adds that wherever trade data is reported, it should ultimately be sent to the home market, and that as a self-regulating exchange with a majority of the volume, SIX Swiss Exchange does screen data for market abuse, although it struggles to do so thoroughly because it does not “see” the market in its entirety.

The cost of market data has also been a contentious issue, fueled in part by large disparities in price across the Atlantic. If a trading firm requires all European market data, it would cost €450 ($546) per user, per month, whereas in the US, the equivalent data would be about €50 ($61), says Denzil Jenkins, director of regulation with multilateral trading facility (MTF) Chi-X Europe, which currently provides its market data free of charge.

Katz dismisses the notion of all trade data being provided for free, however, saying that market forces should set data prices. “Nobody has to pay for our market data—you can take it from other sources,” he says. “But people continue to try and talk down prices with the regulators. What do they have to do with the prices?”

It will not be an easy issue to resolve, says Jenkins. “Lots of solutions have been proposed to reduce the cost of market data, but it is not yet proven whether any of them will work. I would love to say there is a silver bullet, but it’s just not that simple.”

He adds that allowing customers to choose lower cost—or free—data for some areas of the market and filling gaps with feeds from other exchanges, could, in theory, be a sensible solution.

Others have proposed the formation of a US-style consolidated tape, something Jenkins dismisses as a “second best” solution to the problem. If the industry can’t provide a set of standards itself, however, pressure for a consolidated tape will grow.

This is especially the case among investment firms that may not have the financial wherewithal to connect to all relevant data feeds, says Drew Miyawaki, head of European trading desk with buy-side-only crossing network Liquidnet.

“A consolidated tape is what the buy side wants, and we second that. It’s a nightmare trying to trade in some of these markets if you don’t have the right data feeds,” he says. “You are going to miss some liquidity without a consolidated book. Liquidnet has been able to put a lot of technology, money and effort into solving that problem, but the buy side doesn’t have that luxury in many cases, so they are much more reliant on the brokerage community having a solution in place.”

Fear of the Dark

Dark-pool trading has also been a contentious subject, with critics and proponents sniping about the relative merits and dangers of the unfortunately named trading venues amid fears of regulatory crackdowns. In particular, stricter rules on investment bank-owned dark pools have been mooted, with major exchanges including NYSE Euronext and Deutsche Börse arguing that such venues are overly opaque and only open to institutional investors.

Transparency has, of course, been an overarching concern across the market, and concerns have also been voiced about the effect of dark pools on price formation. “We think the focus of the review should be on genuine transparent price formation on lit books,” says Katz. “A lit order book is where all potential members can come together and form a price. Anything else, like a dark pool or crossing network, doesn’t create open supply-and-demand price formation, which is what makes the market function,” he says. “Markets that use the reference price as opposed to helping build it, we think are of lower quality. It’s imperative to get the percentage of lit order book trading up.”

Off-exchange trading has certainly drawn its share of ire, with many citing Federation of European Securities Exchanges (FESE) data claiming that as much as 40 percent of European trading could be taking place away from lit order books. “These figures prompt the question of whether we have too much over-the-counter (OTC) trading in Europe for the purposes of ensuring price discovery,” says FESE deputy secretary general Burçak Inel. “It also prompts queries over what kind of business is conducted in crossing networks and whether it competes against the business done in regulated markets and MTFs unfairly. Our members’ view is that there is a legitimate place for off-exchange trading in European markets. However, the MiFID principle was that this should be the exception, not the rule, and that is what we would like to see in Europe.”

The 40 percent figure has proven controversial, however. In December last year, the UK Financial Services Authority (FSA) said that based on data from six of the largest banks in London, dark pool trading totaled just 1.25 percent of the entire European market.

Whatever the reality, Foster says, heavy-handed dark pool regulation could prove detrimental. “Transparency is great, but there is definitely a place in the market for dark trading. People on the buy side really want dark to work, and if it were to be banned, volume wouldn’t necessarily migrate to lit exchanges or MTFs,” she says. “There’s been so much noise about dark being evil that the benefits have been lost in all of this. It would be a huge loss for trading performance if it were stopped.”

Foster says, however, that some concerns about the quality of different dark venues are legitimate. Instinet currently trades in 12 different dark pools and takes no chances with its due diligence, analyzing the impact and the reversion of trades, sending out details surveys and cutting off venues that do not its meet standards.

High-Frequency Reservations

Regulatory concerns about high-frequency trading are nothing new, but the near-1,000–point intraday drop in the Dow Jones Industrial Average (DJIA) in the US on May 6 has added weight to the calls for tighter constraints on such practices, among them suggestions that so-called circuit breakers should be mandated across all trading venues. “The events of that one day have brought out a lot of issues,” says Katz. “We all love fragmentation, we all love competition, but if one market has a circuit breaker that kicks in and order flow is routed somewhere else where there isn’t one, then the stocks will continue to drop. Orders being routed onward to venues that don’t have the same standards as the primary exchanges is a problem.”

Nevertheless, Katz says more research must be done before clamping down on high-frequency trading. “We don’t think there’s been an in-depth study which looks at the cross-venue effect on price formation, market quoting and market abuse of high-frequency trading, for example,” he says. “Before someone passes an important final judgment on a section of the market that isn’t so well understood, it is worth looking at issues like that.”

With so many high-profile concerns to be addressed, Foster says she fears that other issues may be overlooked—in particular, the unbundling of research from brokerage services. “The opportunities for UK institutions are far greater than they are in Spain, Italy or some of the Scandinavian countries, in that the institutions there don’t seem to be allowed to trade with the people who are able to provide the best execution, because unbundling hasn’t necessarily been ratified,” she says.

This issue was addressed in MiFID’s first manifestation in the “portfolio manager inducements” section, but, Foster says, this is not always common knowledge. “When we explained to regulators that most European buy-side firms still had to direct their trading commissions to brokers in order to pay for research, and as a consequence weren’t necessarily trading with firms that were connected to all the new venues and reaping the benefits of best execution, they believed the inducements clause had addressed this. It is an important area that sill needs addressing,” she says. The solution, Foster says, could be as simple as re-writing certain guidelines to be more explicit.

With the window for feedback now closed, the review is set to be concluded by November, but few anticipate any future legislation to come into force until at least 2012. In the meantime, Katz says an overly prescriptive regulatory approach to any of the myriad issues turned up so far would likely cause more harm than good. “This is one of the most dynamic and innovative industries, so regulators should be careful not to exaggerate the rigidity of any rules. It’s like trying to block a river—the waters will always find a way around,” he says. “If anything is set in stone, we might have to chase the same problem somewhere else further down the road. It is in everyone’s best interests to keep the industry’s drive and innovation, because we all benefit from it.”