MiFID (Markets in Financial Instruments Directive) is designed to provide a legislative framework that will result in a single European market for wholesale financial services and open and secure retail markets within the context of modern prudential rules and supervision. The scope of MiFID is wide-ranging but one of the four most challenging areas in which the directive impacts banks and brokers concerns pre-trade and post-trade transparency, best execution and the complexity of changes required to systems.
Increasing pre-trade transparency
This is one of the most onerous areas of MiFID in terms of potential market risk exposure. The directive introduces a new classification of market participant entitled ‘Systematic Internaliser’ (SI). The exact definition of this term and the criteria by which organisations will be classified as such, are still the subject of debate between the European Commission and various stakeholders: banks and brokers; industry associations; regulators and legislators of the member states. The obligations of an SI are of serious concern to many who would potentially be classified as such. Of particular concern is an SI’s obligation to publish firm quotes for securities in which it executes client orders on its own account outside the rules of a regulated market. This applies to any shares classified as being ‘liquid’ and admitted to trading on a regulated market. Concerning many intermediaries is the potential obligation to publish firm quotes in securities in which they trade low volumes. Without understanding each security, firms will have difficultly quoting at-market prices without exposing themselves to unacceptable levels of risk. This may be particularly galling for those firms who do not have retail customers, but who will have to quote prices in retail market sizes.
There are further concerns. With so many stakeholders in the final MiFID outcome, some firms are strongly in favour of not making the ‘level 2’ MiFID guidance too definitive. Their preferred approach is to leave room for flexibility and later interpretation. This approach may bring additional risks as the implementation deadline approaches and ‘level 4’ enforcement is applied. Firms may find there is no room left to influence the interpretation or to implement required systems changes arising at the last minute. SI classification is a prime example of where such clarification is needed. Our research amongst banks and brokers across Europe has surfaced a variety of interpretations. Intermediaries engaging in similar activities in different EU member states differ in opinion on whether they will be classified as a SI. This presents the EU and regulatory bodies with a challenge in ensuring there is sufficient definition to achieve a common understanding, vital to achieving the objective of establishing a level playing field across all member states.
Achieving best execution
MiFID brings the obligation to ensure that deals are executed on the most beneficial terms for the customer. This has generated a large amount of debate resulting from the ambiguity of the term ‘best execution’. One area of debate is whether best execution should take into account more than just quoted prices by factoring in the whole life cycle cost of execution, settlement terms, currency, volumes, risk, etc. The directive on best execution requires that investment firms perform ongoing monitoring to maintain their understanding of all relevant trading venues. The firms we spoke to challenged the ability to reference and evaluate best execution across other appropriate venues based on anything other than price and perhaps volume.
Firms will be required to publish and adhere to policies of execution, detailing how they will execute client business. Market participants will need sophisticated pricing mechanisms to be able to apply execution policies in fast moving markets if they are to avoid increased market exposure. They must also be able to demonstrate adherence to execution policies for a period of time following completion of the trade. This adds a level of administration dramatically above that which is currently in place within banks and brokers today. We understand that organisations such as the London Stock Exchange have already developed products to allow firms to satisfy the regulators.
Another area of complexity comes from investment firms supporting multiple customer channels spanning electronic and voice/telephone instructions. Of particular note is the debate over the relevance of best execution in the field of OTC derivatives. Besides being virtually impossible to implement in practice, many believe there is little or nothing gained from forcing banks into obtaining ‘competitive’ quotes for bespoke tailored financial instruments.
Post-trade options
Post trade transparency rules under MiFID may increase flexibility in the UK and other member states. It looks likely that there will be increased competition in the provision of services to receive and publish post-trade data challenging long established monopolies held by Exchanges in this respect. However, reporting will be regulated to ensure information is reliable and also that it facilitates consolidation. As discussed in our previous article, there are opportunities for central service providers including Exchanges to offer organisations new services to meet their obligations for regulatory reporting, enabling them to benefit from the resulting economies of scale.
Engaging IT solutions
MiFID brings the widest reform of front office regulation to date, bringing the biggest technology challenge that the front office has seen since the introduction of electronic trading. These challenges are exacerbated by short timescales and the fragmented and diverse technologies typically in place in most bank and broker front offices. The drive to meet demands for providing trading in new markets and products has traditionally led to firms taking a more tactical approach to technology. As a result the typical bank or broker’s front office technology landscape is a diverse array of multiple complex home-grown third party solutions.
External suppliers typically manage a rolling release plan with the delivery of fixes and enhancements scheduled well in advance. MiFID changes are unlikely to have made it onto the release plan of most suppliers for the simple reason that their customers haven’t put it high on the agenda. The challenge for banks and brokers is therefore to understand their specific requirements and then specify them to their array of third party suppliers and plan implementation in time for April 2007. The challenge increases for individual firms when we consider that all their competitors will probably be talking to the same set of suppliers, defining potentially conflicting requirements. This is likely to lead to resource constraints both within firms’ suppliers and their own internal IT department, restricting their firm’s ability to effectively respond to MiFID.
With the introduction of MiFID, banks and brokers face important questions with far-reaching implications. How will MiFID affect our business? What will it cost us? How can we engage our IT department and suppliers to ensure a timely solution is implemented? There is not yet sufficient clarity to say with certainty exactly how MiFID will affect anyone’s operations. However, what is alarmingly clear is that banks and brokers simply cannot approach MiFID as a traditional ‘waterfall’ project. By the time the detailed requirements are understood it may be too late. With a large number of panic-stricken organisations paying whatever it costs to gain compliance, competition for limited supplier capacity may force firms to seek more costly tactical solutions. The winners in the MiFID race will be those organisations who have acted strategically, engaged their third party suppliers and internal IT early on and already have high-level implementation plans in place.
The details of ‘level 2’ implementation are still the subject of great debate and many voices are lobbying the central authorities to influence the next phase of regulatory clarification. Proactive organisations have engaged the industry associations and working groups and the FSA and Treasury and are contributing to the ‘level 2’ debate.
Engaging in this debate offers significant opportunities to understand potential impacts as the detail develops, providing that all-important early-mover advantage rather than simply waiting to be told the final outcome. For smaller firms, the only hope for avoiding consolidation may be to rely on common services provided by exchanges, consortia or outsourced service providers. However, as yet launching such services has only been mooted with no firm commercial commitments. Even with the deadline for compliance extended from 2006 to April 2007, MiFID timescales will be tight. Organisations failing to rise to this challenge face a rapidly growing cost of compliance. Worst case, this loss of early mover advantage may provide real challenges to their survival.
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