The key consultation papers from the Financial Services Authority (FSA) on the Markets in Financial Instruments Directive (Mifid) are out at last, but there is still a vast amount of work to be completed by businesses, their advisers and regulators in the next 12 months before this directive comes into force.
The original plan had been for Mifid to deliver a pan-European set of regulations applicable to all EU banks and investment companies. But political wranglings led to half of Mifid being implemented by regulations (ie transparency in the equity markets) and the other half by way of directive (covering issues such as best execution).
While the regulations were finalised in September, there is still a number of issues to be dealt with. For example, businesses are still waiting for the regulators to agree on the standard technical means by which they report transactions to the regulators. Businesses themselves are trying to work out the way in which they will comply with the new transparency requirements in the equity markets, which may be extended to the bond markets and other financial instruments in 2008, and are also trying to agree common market standards.
Many of these issues involve huge IT system changes, which have long lead times to design, implement and test, and companies planning their budgets for 2007 are geared up for a big expense. Planning seems to be going well, as far as it can with so much uncertainty about the rules, but the risks inherent in trying to force so many changes through at the same time still leave many very concerned.
Missing the deadline
There is even more work to do in relation to the directive part of Mifid, which needs translating into local law in each European Economic Area (EEA) member state. The FSA is the only EU regulator to have set out a formal timetable for consultation and implementation, to which it appears to be sticking. This is good news for UK-based businesses, but the rest of Europe has not followed the same approach and this is a recipe for disaster.
To make matters worse, there even a number of member states that may implement Mifid late, for example the Netherlands, while some may implement on time but without the same level of consultation, giving companies in those jurisdictions little time to prepare in the same way as UK businesses. Member states may decide to implement Mifid in different ways, which will leave opportunities for regulatory arbitrage.
Moves afoot to try to avoid this situation are unlikely to succeed completely. The Committee of European Securities Regulators (CESR) has been charged with the task of trying to develop common standards in many areas, including best execution, but this may lead to rules that the City will not be happy with. The FSA itself, perhaps stung by the reaction to its proposals on benchmarking, seems to be pushing issues back, not only to the CESR, but also to industry itself to develop its own standards and guidance.
Against this background the implementation of Mifid appears to be causing short-term problems and uncertainty for the companies that it was meant to help most – those wanting to do business on a pan-European basis. For example, how will the investment bank with branches in Germany and London cope if Germany implements Mifid late while London implements it on time? Which set of rules should a UK firm comply with for cross-border business? The aim of Mifid was that businesses could operate under a single, unified regime, but that is completely undermined by late implementation.
Even in the UK, where the FSA now seems to be trying to be as pro-business as possible, companies simply hoping to get to the 1 November 2007 deadline with their existing business model intact and with minimal cost are likely to be disappointed. In some areas changes are going to be forced upon businesses, which will be required to restructure, as in the case of the rules on best execution, client categorisation and suitability/appropriateness. Some of these changes will also impact on businesses outside Mifid as the FSA looks to overhaul some parts of its rules across the board.
The cost of implementation
Estimates of the costs for companies in implementing Mifid vary widely, given the uncertainty over the final rules that will be adopted by local member states and the CESR guidance. At the least, there are the significant internal costs in mapping and reviewing existing systems, processes and documentation, identifying and analysing the gaps against the proposed new rules and then designing, implementing and testing new or revised systems, processes and documentation to close the gaps.
Staff will need to be retrained in relation to these changes. Large-scale communications exercises may need to take place with customers to keep them informed about how the changes will affect them. Compliance audits will also need to be carried out to make sure that not only do the systems meet Mifid requirements, but that compliance can be proved.
It is not surprising that many companies are budgeting for a significant spend next year on external consultants and advisers to assist with Mifid in relation to legal, compliance and IT issues in particular. Some of the smarter businesses are being more proactive about Mifid and are seeking specialist advice to help spot the business opportunities. This means not just looking at Mifid as a basis to update some procedures and systems that were due an overhaul anyway, but also to restructure their business models to gain a competitive advantage.
For example, the removal of local protectionist measures, such as the abolition of the concentration rule favouring local stock exchanges, gives investment banks the perfect opportunity to extend their businesses. A group of investment banks has formed ‘Project Boat’ to deal with the Mifid requirements on transparency without paying stock exchanges to deal with it. The same group is also looking at taking on the exchanges directly and has announced preliminary plans to set up a rival trading platform in 2008. At least one exchange, Easdaq, has responded to the threat by forming its own spin-off company to try to offer a more competitive pan-European service.
Why it’s all worth it
The benefits are clear: competition between execution venues – including exchanges, businesses acting as quasi-exchanges and companies offering to buy or sell the instruments themselves – should drive down costs for customers and lead to further consolidation between the exchanges and/or other execution venues as the most competitive and efficient venues win more business.
The opportunities for regulatory arbitrage under Mifid will also be apparent to the smarter companies, especially those that can operate on a cross-border basis without local face-to-face operations (electronically or by telephone). A number of companies (including HSBC) have recently made noises about possibly relocating due to the tax burden in the UK. Will additional regulatory burdens in the UK push some businesses towards making the decision to move?The FSA seems to be keenly aware of this risk. It also seems to be practising what it preaches, climbing down from its controversial proposals on best execution following a huge industry backlash and bending over backwards to simplify its rulebook. However, businesses have yet to be convinced that the FSA will be a more liberal regulator than others in Europe, particularly when it maintains such a large enforcement division. Companies will also want to see how Mifid beds down before making any moves.
For purely domestic UK businesses, Mifid brings about change for change’s sake. The current regime works well and the changes seem unnecessary. However, having gone through all of that pain, surely these companies will look to offset some of the costs by making the most of their ability to carry on cross-border business.
Ash Saluja is a partner at CMS Cameron McKenna