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TagsLondon, 19 October 2011
Deutsche Bank Research: Tomorrow, the European Commission will publish a proposal for a Regulation (MiFIR) and a Directive (MiFID 2) that will extend what is currently regulated by the existing Directive on markets in financial instruments (MiFID).
The existing MiFID created a regulatory framework for investment services in the EU. Some of the new proposals are necessary considering changed market circumstances. Others are at least worth discussing regarding their design. There is a broad consensus on the overall objectives: more transparency and a comprehensive regulation of all market participants and instruments are globally agreed principles. But will the new proposals be able to efficiently eliminate the identified shortcomings?
The Regulation and Directive will contain the following proposals:
* Consumer protection: Stricter rules on investment advice and inducements, telephone recording of transactions/order transmission, extension of the scope to structured deposits and initial public offerings, stricter categorisation of clients, possibly a ban on “execution only” services for retail clients, stricter information duties for complex products
* OTC derivatives: All OTC derivatives that are eligible for clearing and liquid have to be traded via regulated trade venues.
* Algorithmic Trading: Rules for algorithmic trading, liquidity requirements
* Rules for regulated markets, Multilateral Trading Facilities (MTFs) and introduction of a newly defined trade venue: Organised Trading Facility (OTF)
* SME growth markets: Introduction of a new market segment with preferential rules for SMEs
* Extension of pre- and post-trade transparency: Transparency rules apply also to ETFs, certificates, bonds, structured products
* Reporting requirements regarding all transactions to which MiFID applies
* Consolidated tape of trading data: Trading data shall be collected by a central entity
* Best execution: Trade venues have to provide data on their execution quality
* Regulatory framework for commodity derivatives: position limits and reporting requirements
* Supervisory authorities: Harmonised sanctions and the possibility to ban products
The first MiFID led to lower transaction costs and more integrated financial markets. It was adopted in 2004 and implemented in 2007 in the EU Member States. A revision is necessary due to a mandatory review of certain aspects, technological changes (electronic and algorithmic trading) and changes in market circumstances (increasing OTC trading, changes in transparency requirements due to increased competition/more trade venues).
Some proposals are relatively uncontroversial, for example the acknowledgement that OTC trading has a right to exist, some basic rules for algorithmic trading and a consolidated tape. Regarding other points there is disagreement on the “how to do it” aspect. Industry associations criticise the lack of a proper cost-benefit analysis and some not very targeted proposals that do not address market failures and/or may have unintended side effects:
1. The definition of an OTF will have an impact on the functioning of so-called “crossing networks”. Crossing networks are internal closed trading systems within a bank that are currently not regulated. In a crossing network, supply and demand are first matched internally between the clients and the bank where possible. This leads to a reduction in trading costs, and bigger orders of institutional clients may be executed at a lower cost. At the same time, market participants that are not clients are excluded from this service. In order to maintain neutrality, it would be forbidden to cross client orders with the banks’ trading book in future. This means that crossing networks would have to be split, which would lead to lower liquidity. This could result in less efficient order execution and higher prices for clients. Simultaneously, this would reduce the attractiveness of using these “dark pools” (most crossing networks are “dark pools”) where this is not justified by other circumstances (larger order). Regulating crossing networks and other “dark pools” will ensure a fair participation of all market agents in the price discovery mechanism.
2. Industry associations criticise the extension of pre-trade transparency to bonds and structured products since some of them are not sufficiently liquid. It is deemed inappropriate to copy criteria for equities markets to non-equities markets without taking into account the substantial differences in the way these markets operate. In an illiquid market, transparency may be harmful in the sense that already a relatively small transaction may move the price significantly. In general, pre-trade transparency is more important for order driven markets such as the equity markets. Post-trade transparency is more important in quote-driven markets like the bond markets. A respective differentiation regarding pre- and post-trade transparency in equity and bond markets therefore seems reasonable.
3. Regarding commodity derivatives the objective is to prevent speculation. The Commission aims to achieve this, among other measures, by position limits. A position limit restricts the amount of contracts a market participant may conclude within a certain period. The industry is concerned that this could reduce liquidity in the market for commodity derivatives at the expense of all market participants.
4. The Commission also received criticism for not sufficiently coordinating measures internationally. A different regulation for derivative markets in the US and Europe will lead to additional costs for market participants.
MiFID2 and MiFIR will change the framework for all market participants in investment services significantly. The Commission has calculated that the implementation of the new rules would not cost more than EUR 732 million one-off and EUR 586 million annually. Compared to total operating costs in the EU banking sector this would not be more than 0.15% one-off and 0.12% annually. The Commission claims that especially one-off costs are significantly cheaper than with the implementation of the first MiFID. However, it is unclear whether the Commission has taken into account a complete overhaul of the business model when calculating those amounts – because this could become necessary regarding the investment advice process. In any case, estimates of costs are probably rather on the low side since IT implementation of transparency requirements alone will already amount to several million euros per financial institution.
The Commission received 4,200 responses on the consultation earlier this year – normal averages range in the low hundreds. This shows the above-average interest in this dossier that Parliament and Council will have to deal with in the coming months.
Ends --
Deutsche Bank Research
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