The Markets in Financial Instruments Directive (MiFID), also known as the Investment Services Directive #2, promises true trading transparency but at a cost akin to that of dealing with Y2K problems.
What is it?
MiFID targets dealings in the investment markets, and is intended to introduce full transparency in all trading in equities. The commission is considering and extension of the regime to bonds and derivatives.
Who dreamed it up?
The European Commission engaged the Committee of European Securities Regulators (CESR) to draft the legislation. The first draft was issued in April 2004 and was entitled Directive 2004/39/EC.
When will it be implemented?
April 2007.
Who wins, who loses?
The intent of MiFID is that the buy-side are winners. MiFID legislates that investors are made aware of all of the pricing for financial instruments from all of the providers of that instrument, and that they receive the best advice from their investment adviser – their broker-dealer – at the time of a trade. Therefore, there is true market transparency where, for any trade in an equity, (and maybe a bond or derivative), the buyer can be confident that they have best execution from their seller. The loser is therefore the seller who can no longer hide pricing margins from the competition.
What’s in the small print?
A new term known as “systematic internaliser”. A systematic internaliser is any organisation that trades off its own book of business on an “organised, frequent and systematic basis”. For example, if Deutsche Bank runs the majority of equity dealings in BMW shares as a market maker, then it is a systematic internaliser. Under MiFID, anything from 50 to 500 European sell-side operators will become systematic internalisers, depending on the final wording of the legislation. If you are a systematic internaliser, you are compelled to publish your prices through an exchange or other public service (still to be defined) and to store all the market prices from all other internalisers, exchanges and other sources such as cross-networks, for that instrument throughout the working day. If a customer asks you to prove best execution, you must be able to retrieve the exact data for all the organisations dealing in that specific traded instrument at that time of the trade, and prove that you gave best execution.
How much will it cost?
MiFID involves massive data storage and indexing. Alongside the investments required to handle the changes to connectivity – reference data, storage and indexing – are all the opportunity costs and lower margin implications introduced through this transparency. The average investment bank will need to spend around $22m to comply with MiFID, with a further additional cost overhead of around $3m a year to maintain compliance. On that basis, the costs could be in excess of $9bn for all of Europe’s investment industry to comply. In other words, MiFID would cost about the same as Y2K!
The law of unintended consequences
The aim of MiFID is to create a seamless and transparent eurozone trading environment and to stop the off-exchange activities that allow poor client servicing. However, it is the very nature of sellers using off-exchange trading that allows buyers to get higher risk and higher return deals. By eradicating trading off its own book, the sell-side will end up with bland offers that are priced to market. The buy-side will lose out on arbitrage and other leveraged returns, and will move towards automated dealings. The concern of many is that if buyers automate their deals, and sellers cannot differentiate through creative dealing, then the end product is a pure technology play whereby order management systems deal with algorithmic trading platforms and digital exchanges.
