Since the Markets in Financial Instruments Directive (MiFID) was enforced back in November 2007, the economic landscape has changed dramatically. Competition between trading venues has increased while investor choice has improved, due to enhanced availability of financial instruments, reduced transaction costs and increased integration.
As a result of the 2008 financial crisis, both regulators and the G20 are demanding better execution, greater transparency, risk management and regulation of more opaque markets such as over-the-counter (OTC) derivatives. To meet these demands, the European Commission (EC) released MiFID II in October 2011. While not yet passed as legislation, MIFID II will require significant change for financial services firms amid the need to comply with other EU regulatory reforms, as well as US Dodd-Frank reforms.
The Impact on Banks and Financial Institutions
MiFID II is simply the latest in a long line of regulations which require major changes in both internal infrastructure and how companies conduct their businesses on a day-to-day basis. The EC’s own estimates for one-off compliance costs for MiFID range between €512m – €732m and ongoing costs of between €312m – €586m. The challenge for companies, aside from the significant cost burden in an extremely challenged market, is to ensure they don’t fall foul of the regulators – much easier said than done given how quickly regulation is prone to change.
The potential advantages are the harmonisation of rules but it will also be viewed as providing UK entities with less flexibility, particularly for more specialised areas such as commodities. As necessary as this is, the continuation of changing regulation is placing pressure on financial institutions, particularly the sell-side firms, who need to pay close attention to how they adapt their systems and processes to adhere to strict transparency and reporting regulations.
There is little doubt that, for capital market segments, the impact of MiFID II will be felt strongly across all areas of the business and the different operating functions. The revised directives and regulations in MiFID II cover a vast amount of ground and, in addition, the full impact has to be analysed alongside other closely related regulations such as European Market Infrastructure Regulation (EMIR) and Central Securities Depositories (CSDs). Given that some of the revised regulations, including those on trade transparency and reporting, have already led to some objections, there is also the lingering possibility that once companies have put these regulations in place, they will be subject to yet further change.
Regardless of any anticipated changes, the focus needs to be on enhancing the processes and systems for electronic trading (e-trading), risk management, transparency and transaction reporting (across more asset classes), compliance and investor protection. MiFID includes a number of measures aimed at protecting investors in the context of the provision of investment services. However, modifications and improvements are clearly needed to strengthen the framework for the provision of services – whether broadening the scope of the directive to cover financial products (like structure deposits), services and entities which are currently not covered, modifying conduct of business and strengthening organisational requirements for the provision of services to investors, such as adopting and consolidating internal controls.
Another consideration is around data consolidation and dissemination. The reporting, publication and consolidation of trade data needs to be addressed due to problems with its formatting, cost, quality and reliability, with many issues highlighted by the EC.
To minimise the impact of all such changes, and given how often this can change, a carefully planned and phased approach for MiFID II compliance is vital. IT plays a pivotal role in allowing this change to happen smoothly, so it is important businesses think carefully about how they work with their technology teams when implementing these across the entire enterprise.
As it stands, the sell-side firms in their capacity as liquidity providers arguably have one of the biggest challenges to overcome with the introduction of MiFID II. Most of these were using pre-trade transparency waivers provided in the original MiFID to avoid the public dissemination of bid and ask prices and depth of interest creating dark pools, which encouraged buy-side firms to use their services. With these waivers under review as part of the pre-trade transparency proposal in MiFID II, liquidity providers will need to reassess their service strategies in attracting buy-side clients. Similarly with the proposal on regulating the automated trading and high frequency trading (HFT) practices, sell-side firms employing alternative exchange venues, for example broker crossing, will need to adapt their systems and processes swiftly in order to adhere to the transparency and the reporting regulations.
Another point to note is around the proposal of bringing all standardised trading instruments, such as commodity derivatives, under the ambit of the directive. Sell-side firms already engaged in this business will need to establish systems and processes to meet the reporting and compliance regulations that are currently applicable on equity-related instruments.
Additionally, the enhanced requirements for collaterals in the OTC segment, put in as part of risk control enhancement in MiFID II, could reduce the market interest in these instruments, thereby affecting the sell-side firms involved in the OTC segment both in terms of business and changes required in risk monitoring systems.
Finally, since MiFID II’s main focus is on breaking the vertical integration in the sector, with the aim of increasing competition by freeing the clearing service from the trade service, sell-side firms can no longer hope to sell exclusive, fully integrated investment services to their clients. This could represent a significant change to their business model, which is why these companies need to approach the changes presented in MiFID II with careful thought.
However, the full impact of MiFID II on the capital markets and the financial services players can only be ascertained once the legislation is fully in place relative to other regulatory reforms such as EMIR and Dodd-Frank. Firms also need to take view of their front to back office infrastructure and have a holistic view of all regulatory impact on business and infrastructure, rather than taking a standalone approach to MiFID II.
To summarise, MiFID II will encompass:
- The addition of previously-unregulated organised trading facilities (OTFs) to the MiFID framework, whereas MiFID I only covered multi-lateral trading facilities
- New safeguards for algorithmic and high-frequency trading activity.
- Additional and reinforced powers of supervision of derivatives markets, coordinated with the European Securities and Markets Authority (ESMA).
- More stringent requirements for portfolio management, investment advice and other investor protections.
Some firms will re-evaluate what businesses (and products) still make sense. Others will use this opportunity to upgrade their IT infrastructure and ensure a flexible approach to take advantage of the market benefits MiFID II could bring.
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