Every inch of Europe’s trading universe will be touched by MiFID II, which takes effect from January 2018. It may achieve its goals of investor protection and supervisory oversight but this could come at the expense of less liquidity, less competition and a string of other unintended consequences, writes Danielle Myles. 

Collateral damage

     

It is dubbed the most significant regulatory change in European financial markets since the UK’s 'big bang' of deregulation in 1986, and global banks describe it as the largest piece of regulation they have had to implement in a single day. The second iteration of the EU’s Markets in Financial Instruments Directive (MiFID II) will upend the structure and operation of European trading.

It spans almost all asset classes (spot foreign exchange is a rare exception), touches every category of market player, and tackles topics from high-frequency trading to exchanges’ ties to clearing houses, and from best execution to dark pools.

Worth the risk?

The scale of MiFID II – which goes live on January 3, 2018, one year later than originally planned – is apparent from the numbers alone. It is seven-and-a-half years in the making, includes 1.4 million paragraphs of rules and, according to consultancy firm Opimas, will cost the industry €2.5bn to implement.  

But most troubling of all is its unintended consequences. MiFID II’s goals of investor protection, transparency and reduced systemic risk are laudable – but they may come at the cost of less liquidity, a more concentrated buy-side, and fewer opportunities for small and medium-sized enterprises (SME) to access capital markets.

The root cause of these side-effects is policy-makers’ aim to get fixed income to behave like equity markets, which were reformed under MiFID I. But using rules to force markets to act in an unnatural way is considered to be less effective than principles-based rules that work within the confines of market realities.

“There was an attempt – well intentioned, I’m sure – to map out what the industry should look like, but I think that technique of regulating is doomed,” says Barnabas Reynolds, global co-head of financial institutions at law firm Shearman & Sterling. “It hasn’t worked in the past, it won’t work here, and it will have unintended consequences all over the place, as markets are far too complex for someone to specify how they should behave at a micro level.”

Some of MiFID II’s potential side-effects have been ironed out through lobbying and the consultation process. In October, EU and US authorities agreed to recognise each other’s derivatives rules as equivalent; without this, transatlantic trading in certain derivatives would have been effectively banned. But with two months until MiFID II takes effect, brokers, investors and trading venues are still warning of the collateral damage it could inflict on the industry.

Liquidity blues

MiFID II’s most sweeping requirement is pre-trade transparency in bond, structured product and derivative markets. Trading venues must make public current bid and offer prices, and the depth of trading interest at those prices. The goal is to create a price discovery mechanism in fixed income, and to ensure that pricing is ‘fair’ – but making EU markets the most transparent in the world risks undermining their liquidity.

“The issue is that market makers are managing risk. But when the counterparty and the market generally know that a price is being made and what their position is – or the position they are thinking of taking on – that can modify their ability to manage their risk,” says Frederic Jeanperrin, Société Générale Corporate & Investment Banking’s head of market regulatory adaptation and management. “The big question is whether it could lead to less liquidity, whether it will be fragmented, or whether it will disappear when you need it.” 

It is a particular concern for corporate bonds, which (due to their lack of standardisation and Basel III capital charges hitting banks’ ability to intermediate markets) are already short of liquidity. In an attempt to avoid exacerbating this problem, pre-trade reporting will be waived for large trades and trades in illiquid instruments. The much-delayed list of illiquid bonds will be published by the European Securities and Markets Authority (ESMA) in December, but irrespective of which securities make an appearance, market participants do not expect liquidity to emerge unscathed.

They cite a raft of MiFID II obligations that make it more difficult and expensive to be a broker. “The capacity of banks to operate as market makers has already been substantially reduced after the financial crisis and I think MiFID II can only exacerbate this tendency by reducing the number of active liquidity providers," says Massimo Mocio, Banca IMI’s head of global markets.

Trading in commodity derivatives could also be hit by MiFID II’s position limits. They are intended to stop people cornering the market by capping the net position a firm can hold in any contract, but in calculating their positions, firms must include their underling clients’ positions as their own. “You could have 100 customers who each have their own minds and obviously want to manage their positions independently. So the rationale for this is not very clear,” says the COO of European markets at one global bank. “It is not an economic calculation, and it will force firms to manage business in an irrational way.”

A less competitive Europe

Position limits are one reason MiFID II could push trading out of Europe. Another is the 'transaction reporting obligation', which requires counterparties to disclose to regulators extensive details about completed trades. This report consists of 65 fields, including both counterparties’ nationality, passport number, date of birth and home address. Traders acting as agents must provide the details of the individual upon whose behalf they are trading.

A transaction report is required if at least one counterparty is based in the bloc or if the trade occurs on an EU platform (in the latter situation, the venue must provide the report on behalf of any counterparty not bound by MiFID II). This creates the possibility of cross-border regulatory clashes. “Disclosing that level of personal information – and we’ve been making this point to the authorities for many years – frequently comes into conflict with local privacy laws. Even when you can actually pass on the information, there are a number of hoops you must jump through first,” says Jason Waight, MarketAxess’s head of regulatory affairs for Europe.

MIFID II’s requirement that EU entities have a legal entity identifier (LEI), and only trade with counterparties that have one, creates a similar problem. LEIs, which are a unique number used to identify parties to a transaction, are widespread in Europe and the US but are not common in Asia-Pacific. The so-called ‘no LEI, no trade’ rule and regulatory conflicts could prompt foreign firms to avoid EU counterparties and trade venues.

In September, the CEOs of Europe’s four biggest electronic trading platforms (including MarketAxess) wrote an open letter to the European Securities and Markets Authority warning that requiring non-EU firms to adhere to “significant operational, compliance and data protection challenges as a result of choosing to trade on an EU regulated venue, these firms are being incentivised to trade… outside of Europe”.

Mr Waight says the biggest unintended consequence of MiFID II will emanate from Asia-Pacific. “Trading activity among Asian participants that takes place on European venues today almost certainly won’t from January next year. The feedback from our Asian clients has been consistent from the beginning: this is something they will look to avoid,” he says.

Furthermore, trade venues must keep the transaction reports they create for five years, which creates the potential of data breaches. “We are talking about potentially 200 new stores of passport numbers and dates of birth,” says Mr Waight. “As an industry, the risks of holding that information are quite nerve-racking.”

An unbundling issue

Perhaps considered to be the most misguided aspect of MiFID II is its inducements regime, which requires separate payments for research and execution. Referred to as ‘unbundling’, it bans today’s practice of brokers providing analyst reports alongside trading services for a single fee. The goal is to ensure end-investors know how much they pay for research, and that fund managers place trades with brokers based solely on their execution abilities.

It is widely believed that another policy goal was to reduce credit bid-offer spreads, on the presumption they were inflated to cover research costs in a similar fashion to equity commissions. But market participants insist this will not occur. “ESMA is using equity logic for decisions in fixed income,” says Elizabeth Callaghan, the International Capital Market Association’s director of secondary markets practice and regulatory policy. “Even the phrase ‘unbundling’ is incorrect. A bid-offer spread is formed competitively; for bonds there is no such thing as commission into which research fees have ever been bundled.”

Unbundling also directly conflicts with US rules that bar banks from charging separately for research unless they register as an investment adviser – something they have avoided due to the fiduciary obligations it entails. They are not likely to register just to provide research to investors across the Atlantic, meaning they could be shut out of the EU research market.

“Those who drafted this had no idea about these US requirements. The situation is an accidental by-product,” says Mr Reynolds. “It has not been thought through; the people who produced it have been wrong-footed by it.” US regulators are expected to issue a no-action letter, assuring local banks they will not be fined for breaching local research rules to comply with MiFID II, but it’s only a temporary solution.

Punishing SMEs

The inducements regime is also expected to spark a chain reaction that could harm SMEs’ chances of raising funds in the public markets, an outcome that jars with the EU Capital Markets Union initiative. As investors must start budgeting for analyst reports, they are expected to consume less (McKinsey expects brokers’ equity research revenue to drop 30%). This will lead to sell-side analyst job cuts and, in turn, less research being written. Naturally, analysts will focus on the biggest and most-traded companies, for which demand is highest.

In a survey conducted by mid-market, UK-focused investment bank Peel Hunt, 84% of buy-side respondents said MiFID II would affect SMEs’ ability to access capital markets due to less research. “Sometimes we are one of only three brokers writing on a company, and going forward it’s possible there will be only be one,” says Hester White, the bank’s head of client strategy and client relationship management. “These companies are terrified that if they have no visibility in the market, what is going to get anyone to buy or sell their shares?”

In addition to less research, the quality of research is also expected to suffer as there will be fewer contrarian views. This harms market efficiencies and, according to Peel Hunt CEO Steven Fine, could increase the potential for market abuse. “Research has a valuable function in making sure the information transferred from the company to the investor is solid and challenged,” he says. “If you can’t peel away the layers of what they are doing and how they are doing it, things have the potential to go amiss.” This is a particular risk for SMEs, which often have less sophisticated governance arrangements than large companies.

Less competition

MiFID II compliance will also hit small and less well resourced sell-side and buy-side firms – particularly the latter, which have never been subject to this level of regulation before. In relation to research, fund managers will favour bigger brokers that cover a wide variety of sectors, while end-clients will favour asset managers that have announced they will absorb – rather than pass on – the new research costs.

“The bigger managers can pay for it but if you are running a fund with £1bn [$1.3bn] of assets under management or less, you can’t afford that,” says Ms White. “Overall there is less of an impact on very large buy-side and a huge impact on the smaller buy-side. There are some that don’t know if they can stay in business after this. It will drive consolidation, or will make the big bigger.”

The rules also favour passive investors that track indices and so rely less on research. “It seems like in any other industry this regulation would be sent to the antitrust regulators,” says Mark Wade, head of industrials and utilities research at Allianz Global Investors. “It’s punitive to smaller asset managers, and punitive to European active managers.”

Some small buy-side and sell-side firms are looking to outsource their trading to larger competitors, so they can guarantee best execution, pre- and post-trade transparency and transaction reporting without having to create their own systems to be compliant. “The increase in investment needed to build brokers’ infrastructure will reduce the level of competition in the market,” says Mr Mocio. “The big banks will have an advantage, and so at the end of the day, I think the end clients could be at a disadvantage.”

Product governance

Trading aside, MiFID II requires fund firms (as product manufacturers) and those that sell their funds (as distributors) to follow stringent governance requirements to ensure investment products are designed for, and marketed to, suitable investors. It aims to prevent the sale of overly complex products to retail, but it could also prompt distributors to work with fewer asset managers.

Banks distribute about 80% of funds in continental Europe; some are created by an asset manager that is part of the bank group, while others are created by third-party manufacturers. “They could still offer in-house and third-party funds, but for the latter they have to justify that they are the best funds, the selection process and so on,” says Marc-André Bechet, director of legal and tax at the Association of the Luxembourg Fund Industry. “So being able to offer a huge number of funds is something that won’t be easy in the future, so there will probably be a reduction in the number offered by all players.”

These rules were intended for structured products, but they also ensnare the bond issuance process. Underwriters fall within the manufacturer category which means they may have to disclose their issuer fees to prove they do not breach MiFID II’s inducement rules. As one European syndicate head notes: “From a profitability perspective, full transparency on fees is not ideal.”

Silver linings

While there is a tendency to think of MiFID II’s negative side-effects, ANZ’s Darren Evans, who is responsible for business execution in Europe and America, also sees some potentially positive ones. “Increased transparency will be beneficial to our customers but can also benefit us as a bank,” he says. “We will get more visibility on deals we missed. Today we only see a piece of that, so that information can be quite powerful.”

In any event, authorities must review MiFID II’s effectiveness in 2020. Given some of its provisions – namely the cap on dark pool trading – were introduced to unwind unintended consequences of the first directive, perhaps a MiFID III may come to the rescue of liquidity, small investors and SMEs.

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