Global repercussions of MiFID II
This article was first published in World Commerce Review
The landscape in which financial institutions are operating is changing significantly. Technology-led transformation and cross-sector regulations are the leading drivers of that change, bringing major strategic challenges to the industry. Firms that cannot adapt to this digitalised and regulated world will face shrinking margins as a result of growing costs and decreasing relative revenue pools.
MiFID II, which came into force this January, will pose a significant challenge. The regulation promotes market integrity, increased transparency and investor protection, and will redefine the European financial services ecosystem. If it follows the same pattern as MiFID I, which brought changes in transparency and market structure to the equities market, then MiFID II will have a similar effect on OTC products and radically change the conditions for the funds markets.
It is now ten years since MiFID I came into force, and in that time equity trading has moved from a closed community and traditional exchanges to more accessible trading on regulated exchanges and multilateral trading facilities (MTFs). At the same time, we are seeing a more fragmented market and lower revenues due to increased competition and globalisation. One example of those changes can be seen in the Nasdaq statistics for the Stockholm Stock Exchange, comparing figures pre- and post-MiFID I. Recent figures show that almost 50% of trading volume today is made off the regulated market, and international participants now represent two thirds of the turnover in the Nasdaq market.
MiFID II covers a much broader scope of financial instruments than MiFID I, and may bring significant changes to the OTC market structure and the value chain of fund markets, leading to margin pressure for these products. In the same way that MiFID I caused changes in equity trading, MiFID II, in combination with a higher level of digitalisation, will alter the trading landscape for fixed income products and derivatives. One possible scenario is a shift from OTC trading to accessible market places, and market structure moving to the same fragmented model as we have seen in equities, where firms will choose to transact on MTFs, OTFs and SIs. The best execution rules will most likely lead to the introduction of sales trader functions. These must verify prices from several sources and route the instructions for execution in the most beneficial way, similar to an equity smart order router.
Other impacts from MiFID II will come from market transparency requirements to publish quotes and disclose costs and charges. This will increase the cost awareness for clients and reduce the industry revenue pool.
The increased standardisation and harmonisation will drive accessibility and support further globalisation, leading to a shift in trading to market places rather than over the counter (OTC) trading. We are already seeing the impact of digitalisation and the demand for low cost global execution from clients on equity markets, and the same can be expected in the near future from institutional clients with investments in fixed income and derivatives. These drivers will also open up the local markets to international competition.
It is clear that MiFID II will create new pressures on margins and affect the whole value chain in the funds markets. The transparency rules will increase cost awareness among clients, which will have a negative effect on revenue pools for fund managers. At the same time, digitalisation will enable capital to move from actively-managed to passively-managed funds, which will also reduce revenues further. The decoupling of charges for research, which must be accounted for separately, will have consequences for pricing models for sell side and execution fees.
All this adds up to a world where firms will have to deal with revenue pressure, the increased threat of new entrants, buyers with more bargaining power and higher technology costs due to the need to meet multiple regulatory requirements and provide a bigger range of tactical solutions.
In response, players who want to retain their margins must become more effective, and that may mean making painful decisions about the future scale and scope of their company’s operations. To do this well requires a detailed analysis, an extensive re-design of the business and a clear understanding of the strategic decisions needed.
Firms should also look for new opportunities. For large companies, those opportunities will come from expanding into new markets and competing on large volumes and lower cost with smaller local players. They will be able to draw on their global experience and operational excellence across delivery channels and efficient management of resources. Equally, companies that are already using technology to reduce cost and achieve efficiency will have a competitive advantage.
Therefore, local players will need to prepare for the arrival of new entrants. Even profitable medium-sized players should be exploring the impact of increased competition as their traditional approach of offering a full range of services will make them vulnerable in this new world. They will have to take a hard look at where they are truly competitive, where they offer high quality service and, more crucially, where they can differentiate themselves from their competitors. Where they can’t do this, they will have to divest or outsource non-profitable businesses.
This requires action now. Sitting back, resting on the laurels and just hoping to react to developments as they happen is a recipe for failure. We are entering a brave new world and companies need a clear and proactive strategy to deal with the changes ahead. Further iteration is surely around the corner. Those companies that took short cuts on MiFID I had greater challenges implementing MiFID II. After a short respite, we should all be ready for taking on the challenges of MiFID III.
Jan Hanika and Tim Sundberg are financial services experts at PA Consulting Group