The EU is hurtling towards the implementation of MiFID II, a huge body of rule changes that no one will be ready for. Some regulatory flexibility will have to be shown or the process may end up resembling a car crash. By Justin Pugsley.
What is happening?
The incoming Markets in Financial Instruments Directive (MiFID) II rules are becoming a huge headache for financial firms and could be disruptive to banks and markets when they come into force next year. On January 3, 2018, financial institutions operating in the EU are expected to be compliant. There is just one (rather big) problem with the deadline, however: nobody will be ready for it, not even the big global banks with all their resources or even the regulators who are expected to oversee compliance. Meanwhile, member states are supposed to implement it into their domestic legislation by July 2017, and that will be quite a challenge.
To make things worse, European Commission officials are telling anyone who will listen that there will not be another implementation delay (MIFiD II was supposed to come into force on January 3, 2017).
This has left many in the industry fretting over the prospect of regulatory actions such as fines and sanctions, in some cases through no fault of their own.
Why is it happening?
The big themes behind MiFID II are investor protection and transparency, both very laudable goals. However, in practice, this means capturing vast amounts of data. For example, for certain transaction reports, the number of data fields that needs filing rises from 23 to 81. Compliance is only possible by investing significantly in technology, automated processes, compliance staff and new procedures.
Also, MiFID II covers many more markets and asset classes than MiFID I, meaning that many more firms and departments are caught up in it. And it gets worse.
Regulators are themselves struggling to be on time, and for elements such as trading obligations for derivatives, they very likely will not be ready. This leaves the industry facing the frightening prospect of having to deal with unfinished rules and, worse, little or no regulatory guidance.
That means all kinds of loose ends around definitions, taxonomies, instrument classifications and client communications, all representing potentially costly regulatory pitfalls.
There is more. US regulatory bodies have the discretion to send so-called ‘no-action letters’ to market participants, meaning they will not be hit with regulatory sanctions if they can not fully comply with certain requirements. Typically, this is done to preserve the smooth functioning of markets in light of new rules, for example. Unfortunately, the EU has no such tidy legal mechanism. Ultimately, even delaying parts of MiFID II would invoke time-consuming regulatory changes involving the European Parliament.
A small glimmer of hope is that the European Securities and Markets Authority has acknowledge the need for a similar EU instrument to no-action letters. But it may not be in place by early next year.
What do the bankers say?
The banks are sweating over MiFID II as they worry about falling foul of regulatory sanctions. They are also concerned about potential market disruptions and damaged client relationships. At the same time, they desperately want guidance and clarity from regulators.
In the absence of clarity, banks will resort to the most conservative interpretation of the rules, hoping to avoid penalties and to show regulators that they are striving hard to be compliant.
Will it provide the incentives?
Investors may end up being better protected, but markets could suffer in terms of liquidity, particularly at the start of 2018. There will be many uncertainties around pre-trade transparency, for example. Initially, some rules that apply to one group of participants, such as trading platforms, will only later be mandatory for others such as banks, potentially creating market distortions.
Many Asian investors, if they can, are already avoiding European markets, which could be a omen of longer-term problems. Meanwhile, smaller and more marginal clients may get dumped as banks retrench to their core clients. Where there is a lack of clarity, banks will make their own individual judgements about the meaning of rules, creating scope for confusion.
Investors could find that even more illiquidity in secondary markets and fewer service providers add up to bigger spreads and higher charges, which will be a drag on their returns. The industry is hoping that the situation will work out as participants learn to adapt to new processes.
Regulators, meanwhile, will need to be patient and flexible and make more effort to guide the industry rather than resorting to fines and other sanctions. If not, there could be quite a knock-on effect on some of Europe’s capital markets.
