14 March 2011
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A crucial consultation over the future of MiFID has just concluded. Damian Carolan reports on the industry’s worries over increased regulation
When the Markets in Financial Instruments Directive (MiFID) was implemented across the EU in November 2007, it was considered a major step towards a European single market for financial services.
The directive embedded a minimum harmonised regime across Europe for licensed investment activities and services and a detailed conduct of business regime to deliver investor protection. It also provided an effective passporting regime allowing investment firms and trading venues to operate cross-border on the basis of home-state supervision.
Although a review of certain aspects of MiFID was always anticipated, events since November 2007, including the global financial crisis, have resulted in the proposal of a far more significant overhaul. On 8 December 2010 the European Commission published its consultation on revising MiFID, with the consultation period closing on 2 February 2011.
The timetable for the changes is aggressive, with legislation to be passed by the end of 2011, and the agenda is ambitious. Whatever view one takes on the policy justifications for the review, there is no doubt that it will have dramatic implications for the way in which financial products are traded and financial services are delivered in Europe.
The review has four main objectives. It proposes changes in both market structure and technology that could affect the smooth and efficient functioning of EU financial markets, taking into account in particular the rise of broker-crossing networks and other new trading facilities venues, as well as technological innovations such as algorithmic or high-frequency trading.
It suggests tackling underregulated and opaque aspects of the financial system, especially in those instruments traded mostly over the counter (OTC).
The review also aims to improve oversight and transparency in commodity derivatives markets to ensure these markets function efficiently, particularly for hedging and price discovery purposes.
The overhaul is aimed at improving investor protection, especially relating to the provision of investment advice and the protection needs of investors in relation to more complex instruments.
While these objectives are positive in principle, the Commission’s proposals to deliver them have evoked strong reactions. The consultation has received an unprecedented number of responses (more than 4,200). There remain major question marks over the proportionality and effectiveness of many of the proposals, as well as wide calls for a proper cost-benefit analysis.
When it comes to market structures, the Commission aims to regulate adequately all kinds of organised trading and to deliver a level playing field in the EU. The proposals are broad-ranging and will impact on many existing market structures and practices.
As expected, there is an intention to bring the regime for multilateral trading venues (MTFs) more closely into line with the higher standards applied to regulated markets.
More significantly, the Commission suggests introducing a new MiFID category of an organised trading facility (OTF), subject to certain core requirements for the operation of a trading venue. OTFs may capture all manner of discretionary and non-discretionary, bilateral and multilateral methods of trade execution in equities and non-equities.
Systems operated by investment businesses that mainly match client orders internally will be captured within a sub-regime of the new OTF categorisation. Systems that have so far been operated by investment companies as an extension of their brokerage business would in future be subject to new authorisation, transparency and oversight requirements.
The G20 commitment states that “all standardised OTC derivatives contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end 2012”.
In order to meet this commitment the Commission proposes that all trading of derivatives that are eligible for clearing and sufficiently liquid move to either regulated markets, MTFs or to a new specific sub-regime of the new OTF categorisation. This proposal will be of particular concern if it does not include appropriate flexibility and exemptions. For many, the case for mandatory trading rather than a market-driven use of trading venues has not been made and its introduction could stifle innovation and damage liquidity in existing markets.
There is also a range of initiatives designed to curb some ’automated’ trading practices that are perceived, rightly or wrongly, to be detrimental to the operation of traded markets, which will impact on traders, their brokers and service providers.
As well as an increasing the level of regulatory oversight of entities carrying on such business, some of the proposals could be far more damaging to the business models of high-frequency traders, including the imposition of onerous obligations of liquidity provision.
The Commission believes that transparency of market data (including pre- and post-trade data) is crucial so that all market participants have equal access to information on trading opportunities, and also to facilitate price formation and promote liquidity. However, the proposed extension of MiFID-style transparency requirements to a whole range of non-equity asset classes has revealed the limitations of regulatory structures that were designed primarily with equities in mind.
Currently MiFID transparency rules only cover shares. The consultation proposes their extension to other financial products, including bonds and OTC derivatives. While pre- and post-trade price transparency obligations are familiar for equities trading venues, they have not historically extended to other asset classes such as debt securities and derivatives.
Having said that, market solutions of various style and degree have developed for those other markets in line with market needs. There is concern that any regime should be appropriate for the particular asset class in question and take account of the nature of that market and the existing availability of market data.
In many cases the industry clearly perceives that there is no real failure that regulation is needed to address. Applying new and inappropriate requirements raises issues running from the basic costs of increased and arguably unnecessary systems to more fundamental concerns that the liquidity will be driven out of certain markets.
There has been broad support for the introduction of a consolidated tape for equities trading in Europe. The proliferation of execution venues for equities that MiFID facilitated has resulted in a fragmentation of sources of executed trade data, so a consolidated source of data for investors appears to be a viable way of addressing this.
Dark trading pools (trading venues where there is no or limited price transparency) currently rely on certain exemptions that MiFID contemplated from transparency requirements. While the exemptions that facilitate dark pools look as if they will survive the MiFID review, there will be increased scrutiny and consistency as to how they are used. The growth of dark pools clearly continues to trouble regulators to some extent, but the Commission has acknowledged the continuing policy justifications for the exemptions that allow them to operate.
The Commission has suggested revisiting various elements of the investor protection regime, including reconsidering client categorisation processes, extended suitability obligations, enhanced information disclosure in relation to complex products, restrictions on inducements and more onerous inducements disclosure, enhanced best execution information and the introduction of the principle of civil liability of investment businesses in areas concerning relationships with clients. The proposals relating to investor protection include potentially onerous provisions on reviewing and reporting to clients on the continuing suitability of investments.
However, responses to the consultation have argued that current MiFID provisions remain fit for purpose and that the proposed changes are disproportionate, driving costly changes to investment businesses’ processes and client documentation with little or no perceived benefit.
European regulatory bodies have traditionally had a limited role to play in active regulation of the financial markets, instead playing more of a technical consultative role. The MiFID review consultation picks up recent changes to the European system of financial supervision, in force from 1 January 2011, and proposes that a broad range of powers and mandates for technical guidance be vested in the European Securities and Markets Authority (Esma). The significant role that Esma has to play in the regime going forwards is something that all market participants and their advisers will need to come to terms with.
The Commission considers that it should, upon receipt of advice from Esma, be empowered to ban certain products or activities if it considers that the services are provided in a way that gives rise to ”significant or sustained” investor protection concerns, or the product or service in question threatens “the orderly functioning and integrity of financial markets or the stability of […] the financial system”.
This is a dramatic extension of powers, the exercise of which could have a serious economic impact on markets, and many responses have voiced concerns.
Some of the Commission’s proposals will undoubtedly be softened or refined as the legislative and lobbying processes run their course. Given the brevity of the original consultation, one hopes that the Commission will be open to detailed further engagement with the industry on issues of flexibility, proportionality and calibration of proposals for particular markets.
Nevertheless, there will be significant changes to trading structures and a potentially dramatic impact on classic OTC dealer business.
The impact of the proposals in the MiFID review must not be viewed in isolation – they are part of a jigsaw of current proposals for increased regulation in financial products that encompasses EU initiatives such as the proposed regulation of OTC derivatives, central counterparties and trade repositories and the Commission’s initiative to harmonise the conduct of business regulation of packaged retail investment products.
Whether the perceived investor protection benefits of the proposals will outweigh the inevitable costs to the market - both the economic costs of a much greater compliance burden and the loss of free-market flexibility - is the big question.
Damian Carolan is a partner at Allen & Overy