On the surface, exchanges have a much simpler task than investment banks when preparing for the Markets in Financial Instruments Directive. Although there will be a low-effort, low-cost, option for compliance, MiFID presents wider potential challenges for exchanges (and banks) that will force them to look beyond these requirements. Exchanges that wish to manage the competitive threats and profit from the new opportunities that MiFID will present must adopt a strategic approach.
Rather than dissect the detail of the directive and associated consultation papers, this article looks at the specific challenges that European exchanges face. The details of MiFID will become much clearer in the last quarter of 2006, and the impending consultation papers and industry guidance (not to mention the level three text) will trigger a great deal of debate. The basic requirement for exchanges to act strategically will, however, remain; exchanges must manage the impact of their customers' order execution policies and address changes to their price transparency mechanism.
Will price transparency protect exchange order flow concentration?
Price transparency and order flow concentration have been the most contentious issues in the development of MiFID. Much of the debate has focused on how regulated markets can maintain fairly priced, deep and liquid markets if their published prices can be exploited as benchmarks to price off-market trades and deprive them of the order flow needed to determine them in the first place.
Back in November 2005 Charlie McCreevy, EU internal market commissioner, thought that MiFID would "dramatically increase levels of competition between execution venues and investment firms". On the face of it, however, exchanges, as regulated markets, have won significant protection from MiFID. Their off-market competition, multilateral trading facilities and systematic internalisers will be subject to similar pre- as well as post-trade transparency regimes (only in shares at the moment, but this may be extended to other instruments). Further, the MiFID regulations essentially endorse the regulations of most existing markets; best execution and order priority rules in particular will correspond to standard market system practice.
A fragmented market picture creates opportunities for exchanges
At the same time as extending the scope of post-trade transparency reporting, MiFID allows investment firms to choose the venue through which they report. Firms can report though a regulated market, MTF, third party or their own proprietary mechanisms. This choice could fragment market transparency with the full market picture being split across multiple reporting channels.
Exploitation of these new channels may create opportunities for new execution venues to attract attention as the first step to gaining liquidity. The response to this threat from regulated markets could, in principle, be as simple as ensuring there is an aggregated view available, but this may not happen all on its own. This in turn presents an opportunity for exchanges to build a richer market picture that includes transparency from other venues that may help to consolidate market data revenues.
The reigning champions are confident, but the game has changed
The central exchange markets remain confident, and history is mostly on their side. Market impact (the influence a transaction has on price movement) is a major factor in determining price, which favours the concentration of order flow. Successful exchanges concentrate order flow in venues that are both rich with active investors and market information. As a result, few newcomers have been able to poach liquidity from established marketplaces (ICE being a notable exception).
MiFID, however, fully legitimises internalisation throughout the EU. This allows SIs to operate across the EU with single-country authorisation and guarantees them access on equal terms to regulated infrastructure. It also permits them to choose the channels through which they comply with the transparency and reporting requirements.
This removes many of the secondary barriers that can stop order flow from migrating from established trading venues and puts SIs in a prime position to benefit. When you consider that software and new regulations have already eroded the significance of location for access to markets, company news and investment research, then it is clear that the rules of the competition to capture trade flow are about to change radically.
Lose concentration and you lose the game
With most of the secondary barriers to loss of trade flow removed and a complex best execution rule, the impact of which cannot be easily forecast, the outcome of the post-MiFID competition between trading venues is no foregone conclusion. The danger for established venues is the same self-reinforcing concentration effect that currently protects them. It allows established venues to retain their trade flow even if they offer worse value-for-money for their own services, due to the reduced costs of market impact. Only a small loss of concentration can increase market impact, raise overall costs above the competition and lose trade flow irretrievably in favour of a more efficient venue.
Recent history, on the other side of the Atlantic with ICE and Nymex competing over the WTI oil contract, has shown that liquidity will shift given the right stimulus. In this case ICE allowed players easy and cheap access to trade Brent/WTI spreads resulting in a rapid, and at time of writing continuing, shift in market share. Nymex's attempt to fight back through improved trading access via the Chicago Mercantile Exchange's Globex platform demonstrates that the exchange believes simple measures will be sufficient stimulus to restore the status quo.
Liquidity pools have not been contested this fiercely in Europe in recent times but exchanges must not fail to consider that MiFID could open multiple opportunities for competing exchanges, MTFs and systematic internalisers to make a play for their liquidity
Understanding customer order execution policies is essential
So what do established markets need to do to minimise MiFID risks and maximise opportunities? As an absolute minimum, a trading venue needs to know where it will stand in the order execution policies of its customers, and be ready to make changes to ensure that it comes out best enough of the time to protect its concentration. It will need to address all of the factors of price, costs, speed and certainty of both execution and settlement for the sizes and types of trade expected. A trading venue must also:
- discover its customers' priorities for the execution policy factors
- model and predict its own performance compared to competitors
- decide whether to solve the problems through pricing or service change
- design, plan and implement the changes by November 2007
This involves a major programme of market research, scenario modelling, strategy and business case assessment, and process and system change management. With 18 months to go, all but the smallest marketplaces should have this programme well under way.
There is already evidence of strategic action from Europe's stock exchanges, for example London Stock Exchange and Deutsche Borse have been busy marketing new services to help ease the regulatory burden of MiFID on their membership with services to help demonstrate best execution. It is no coincidence that these services also lessen the imperative for members to seek alternative trade venues. Exchanges that fail to act strategically to strengthen or defend their position may find themselves outmanoeuvred by the savvy exchanges and new marketplaces which are certain to play to win.
