MiFID II – Unintended Consequences or Potential Opportunities?
Monday 19th February 2018
As we all know, the biggest regulatory change of recent years, MiFID II, came into force in January 2018 and it would be amiss of me to discuss the potential opportunities MiFID II brings without mentioning the complexities, delays to timelines, extent and more pertinent incomplete implementation.
However the challenges of MiFID II perhaps can be appreciated by considering its inception was in the wake of the 2007/08 financial crash, when despite the recent implementation of MiFID in November 2007, and following 2 years of debate on whether further regulation was required the European commission finally adopted a legislative proposal for the revision of MiFID in October 2011.
A further 3 years later, the Level 1 rules were finally published in July 2014 and, with many further discussions and analysis on interpretation in industry forums continuing to this day, there are still aspects of the regulation that are unclear. It is therefore understandable that as we approached 3rd Jan 2018, the focus across the industry was getting over the line with their best effort at implementing and complying with the complex MiFID II and MiFIR requirements, following the culmination of an unfathomable number of man-years since MiFID II Level 1 rules were published in July 2014 and with more work to come throughout 2018.
While go-live went smoother than some expected, others believe the complexities and depth of the regulation are no longer as relevant in the current landscape as so much has already changed or progressed since pre-2008. The complacency seen across the global banking industry and lack of appreciation for the risks associated with any investment decision are no longer as commonplace. This is due to the UK and EU regulations that have already been implemented since 2007, ‘with more than 80 substantial rules and pieces of legislation passed’ 1’ firms need to have tighter controls, more capital, better accounting practices and a stricter accountability regime to name only a few. In this industry it is understandable why many market participants are critical of the content of any new regulatory reforms. While accepting they need to comply with MiFID II and other regulatory reforms to avoid regulatory fines, reputational damage and ultimately improve the efficiency of the markets in which they operate, the firms should not only review their offerings to ensure viability but look for the opportunities that compliance will provide.
The full impact of MiFID II on the new environment is yet to be seen, with the aspiration of the regulation to ‘improve the functioning of financial markets making them more efficient, resilient and transparent’ 2, but there are some that question the impact on liquidity and ultimately true impact or unintended consequences of the regulation. Some firms have identified these unintended consequences as risks to their business model which subsequently can be viewed as opportunities for other market participants.
Exchanges v Systematic Internalisers
Exchanges prior to 3rd Jan were already addressing the risks to their business that MiFID II would bring, and highlighting the unintended consequences to the market. With the publication of data relating to caps on dark pools now delayed until March 2018 there is some relief for the exchanges that were under the impression that this element of the regulation was going to result in a disproportionate suspension of stocks traded on Regulated Markets (RM), Multilateral Trading Facilities (MTF) and Organised Trading Facilities (OTF) and therefore benefiting the Systematic Internalisers (SIs).
An additional consequence and potential advantage to the SIs over the Exchanges is in relation to the inconsistent application of the ‘tick size’ regime meaning the SIs could technically win trades on price improvements not available to the exchanges. However the SIs to date would appear not to be taking advantage of this.
“Tower Research Capital, Citadel Securities, Sun Trading and XTX Markets Ltd. All said they have decided not to use the pricing advantage.” 4
This could be due to the fact that the new SIs are still trying to win clients to use their services. The feedback to date is that the larger clients they are chasing are more interested in big trades rather than smaller tick sizes. Perhaps another reason they have not taken advantage, is the associated benefit was not in the spirit of the regulation and likely to be short-lived especially with the release of the Consultation Paper in November 2017 regarding amendments to RTS 1.
The SIs are using other advantages to sell their services to clients e.g. execution fees, leveraging the best execution rules and trade reporting. It remains to be seen in the coming months if the expanse of the SI regime and the associated obligations, which pre and post trade transparency along with transaction trade reporting are examples of, will impact as intended and assist in the overall aim to bring more transparent and efficient trading to the industry.
MiFID II not only aims to improve transparency but also provide more choice on where to execute trades, through the expanse of the SI regime and with the introduction of the OTFs. However with many more venues available also comes the ability under MiFID II to report transactions to a number of different platforms and it would appear to be diluting the transparency previously available in a number of the European Bond markets.
Referring to the Danish Mortgage Market Jorgensen states “The old rules are actually better than the new rules.”3. Norway would also appear to be having similar issues with transparency under the new rules as Magnus Vie Sundal also stated “MiFID II has currently contributed to less transparency”3
To have a clear view of the market it will require the aggregation of the data across all the available platforms under MiFID II however, industry bodies are of the opinion this is merely a technical challenge and will be resolved, thereby erasing any issues currently experienced. This again highlights that 3rd January 2018 is only the beginning of a new environment and further work and adaptions are required to ensure the overarching aims of the regulation are achieved.
Will there be more choice?
While more choice may be available to the investors on platforms a further unintended consequence as a result of the new rules on research unbundling will be the reduction of research offerings across the industry. The consequence of transparent research costs has resulted in firms reducing the research and advisory budgets and subsequently job losses in this area. While investor protection is at the forefront of the change and it will provide investors clearer views on the price of services, there will be an increase in competition and this may also support a move to more passive funds. The larger investment firms are expected to restructure their departments and smaller research firms are expected to experience significant pressures in order to remain viable.
"The reality is that the relationship between the providers of research and institutional investors has deteriorated and the economics of research are harsher than ever." 6
Others argue that as investors push for better quality or more in-depth research for their money the specialist / independent research firms will win out in the end. Questions still remain regarding the coverage of research as it may no longer be viable to provide research on smaller companies.
Quinlan expects “more analysts will leave big banks to join or start their own independent research providers, with global banks forecast to experience considerable top-line revenue pressure in their research departments".6
Research is unlikely to be the only product or service impacted, as the MiFID II obligations may simply mean that offerings across the industry may no longer be viable. The recent announcement regarding the closure of ‘Avaron Eastern Europe Fixed Income fund, due to MiFID II requirements now imposed on a fund with a strategy that was in place for 6yrs’ 5 is unsurprising and it is expected that more will follow. Within the larger investment firms they may simply cease to trade some products as the cost of compliance outweighs the commercial benefits however there may be an argument that MiFID II has simply expedited the natural progression to more electronic trading and streamlined offerings.
Increased Electronic Trading
While many industry specialists had speculated that the introduction of MiFID II would restrict market activity, electronic trading has actually increased. This could be argued as a reasonable adjustment as trading through the electronic platforms assists with many of the obligations under MiFID II. In addition to the implementation of MiFID II in January there has been the significant increase in market activity globally since early February due to unfamiliar concerns regarding increased inflation in the US (not seen in recent years). This progression away from the more traditional voice trading may again result in job losses or restructuring across the industry. However in this technologically advanced age, this cannot be solely blamed on regulation as electronic trading provides not only assistance with auditing and surveillance, but it also mitigates the risks associated with human interaction and provides a more efficient and competitive trading environment.
There are many more open questions with ESMA, regarding data requirements, consistency of interpretation and implementation across the EU. However, with all the challenges ahead in fully implementing MiFID II throughout 2018, firms have the potential opportunity to meet their requirements under the regulation, improve their reputation and be leaders in the industry with their solutions to the unintended consequences.