The implementation of MiFID has served to reduce transparency across the European market, causing confusion and uncertainty, writes Michelle Price.

The MiFID dream is the creation of a highly transparent single European market for trading, in which buyers will necessarily obtain competitive prices for their securities, executed at lowest cost. Every regulatory change has its teething problems and MiFID, launched with great fanfare in November 2007, has had plenty. All the same, it is now becoming clear that it is not delivering – and may never deliver – on its initial promise.

In the words of Richard Balarkas, president and CEO of Nomura-owned agency broker Instinet Europe, “the market didn’t really get its act together for MiFID”. Several immediate failings make MiFID look increasingly shaky: lack of both preparedness and commercial incentive has seen many brokers fail to connect to new competitive trading venues and instead direct order flow to their internal liquidity pools. They are not, however, being held to account for depriving their clients of the choice of execution venues under ‘best execution’, which has turned out to be all but immaterial.

Meanwhile, MiFID’s avowed aim to improve market transparency has been undermined by the emergence of multiple ‘dark’ venues operating on a non-displayed basis, which has left many traders uncertain as to the location and true volume of liquidity.

Most critically of all, however, the regulators have failed to establish proper provisions for post-trade reporting in the new competitive landscape. This has plunged the London market, which enjoyed a rigorous post-trade reporting mechanism prior to MiFID, into total confusion. As such, says Mr Balarkas, “It is just incredible how ignorant people have been about equity market structures and how fragmentation will affect them.”

Now, many City practitioners are wondering: is the MiFID dream starting to crumble?

Nice idea, poor execution

Nowhere is this question more pertinent than in the case of best execution, one of the most prominent and hotly-debated features of MiFID from the moment of its unveiling. Under best execution, sell-side firms are obliged, in theory, to demonstrate that they have executed on behalf of their client at the best overall cost.

The Banker has learned, however, that a large number of brokers are unable to properly discharge their duty in this regard because they still have yet to connect to the new alternative execution venues, the emergence of which is explicitly encouraged by MiFID in order to raise competition against the incumbent exchanges.

This issue has arisen because the European Commission provided no regulatory definition of best execution, rendering the well-worn phrase largely meaningless. Brokers are able to draw up their best execution policies internally according to their own commercial priorities. There is no stipulation under best execution (despite the Commission’s avowed aim to foster competition) to connect to new platforms, or to offer a choice of independent execution venues. As a result, says Mr Balarkas, who was previously global head of sales at Credit Suisse Advanced Execution Services, “You have this crazy situation where some of the biggest brokers have yet to do a trade on many of these new ­venues.”

Take Deutsche Bank, for example. The top-tier investment bank proudly announced on June 16 that it had executed its first trades on Instinet-owned Chi-X, the pan-European equities platform that, at the time of writing, has secured about a 14% market share of the FTSE 100 stocks. The fact that Deutsche Bank’s connection to Chi-X trailed behind many of its peers, coming more than eight months after the implementation of MiFID and some 14 months after Chi-X began trading, should in fact be a matter of “embarrassment”, says one broker.

Nevertheless, Deutsche Bank’s statement provides a rare example of unwitting candour. In other cases, however, brokers may be disguising the problem. Both buy- and sell-side practitioners report that some brokerages, particularly those occupying the second- to mid-tier bracket with limited capital expenditure to invest in the necessary technological infrastructure, are not making the limits of their connectivity capability clear to their buy-side clients. In this regard, says John Barker, managing director of block-trading network Liquidnet Europe, “there are a lot of things that the brokers don’t want the community to know”.

This is also true of some brokers that are connected to alternative venues: in the words of one well-placed source, many brokers are being “economical with the truth” regarding the volumes they are presently sending to Chi-X. Meanwhile, even those brokers boasting connectivity to a number of venues are not necessarily able to provide their buy side clients with detailed information as to where exactly their trades are being executed. In short, says Mr Balarkas, the buy-side firms are finding it extremely difficult to determine exactly what services their brokers are capable of providing.

Internalisation versus opportunity

To some extent, this problem is explained simply by poor preparedness: few brokers, for whom technology is a hallmark of competitive differentiation, are willing to admit failings in this regard. But it also reflects the extent to which the broker community is expected to bear the associated infrastructural costs of competition.

This burden is necessarily making for a difficult transition. “The market is in flux,” says Bryan Koplin, executive director, equities, Goldman Sachs International. “Everyone is figuring out to whom they should connect, when and how. I can appreciate the buy-side frustration of trying to distinguish between one provider and another. The sell side needs to specifically answer questions when asked on breadth, logic and performance of their respective offering.”

But infrastructural preparedness is only half the story: transparency surrounding trading execution is also undermined by the commercial incentive, on the part of the brokers, to direct client order flow towards their own internal sources of liquidity. These include internal crossing networks, on which client orders are matched against one another, as well as prop desks.

The practice of internalisation has effectively transformed many banks into mini-execution venues. But by directing client order flow internally, brokers are able to legitimately avoid the fees associated with executing their clients’ trades on exchanges or multilateral trading facilities (MTFs) while charging the same commission.

  It is not therefore in the interests of many brokers to send order flow to external venues if they are able to execute internally, says Tony Whalley, head of dealing and derivatives at Scottish Widows Investment Partnership (SWIP). “The sell side are giving the impression that they are sending huge amounts to alternative venues when in fact what they are trying to do is internalise as much as possible,” he says.

Internal liquidity pools will often provide a fine price improvement on the spreads (the difference between the bid and offer) on the independent execution venues. Mr Whalley believes, however, that the practice of internalisation in reducing the number of venues to which his orders are routed actually decreases the chance of finding a “decent fill” for his order.

Although this “opportunity” cost, as it is frequently called, remains largely unknown as yet, research conducted by Instinet (which, as an agency broker, does not operate a prop desk) suggests it can often be as high as four basis points. “Best execution is not just about price,” says Mr Whalley. “It is about a number of factors, including having a choice of venue.”

Brokers maintain that the practice of internalisation, in that most of the liquidity is not displayed to the rest of the market, reduces the market impact costs (the cost associated with movements in the share price when trading in large blocks of shares).

But many institutional traders believe it is still too early – if not a little naïve – to assume that this cost-saving outweighs the opportunity cost or, moreover, that it will ultimately be passed on. As one disenchanted institutional manager says, “I know it will be cheaper for them but will the extra few basis points be saved by us? I doubt it.” Many brokers are unsympathetic on this point however. If buy-side clients are unhappy with their brokers’ policies on internalisation, suggests one broker, they are free to go ­elsewhere.

Less easily dismissed, however, is the concern that large-scale internalisation privileges the broker community with too much information regarding buy-side order flow. The Banker has learned that some London-based brokers are now claiming internalisation rates nearing 30%. Anthony Kirby, director, financial services advisory, regulatory and risk management at Ernst & Young says this figure is very high: “It does raise the question as to how this is achieved.” The conclusion drawn by some participants is that a large proportion of trades are being executed on internal prop desks. This practice offers prop traders unprecedented insight into client trading strategies.

More broadly, the fear that banks will be tempted to interrogate client order flow in order to profitably reverse-engineer their trading strategies is strong, particularly as market fragmentation under MiFID threatens to render buy-side firms ever more dependent on sell-side services.

The London Investment Banking Association did not respond when approached by The Banker regarding this issue. A recent survey conducted by consultancy Richard Davies Investor Relations found, however, that more than two-thirds of fund managers believe conflicts of interest at their broker-dealers have a negative impact on their trading activity. Eliminating conflicts of interest was also a stated aim of MifID that has yet to be fulfilled.

Into the dark

Not all MiFID-related problems reside exclusively in the realm of the brokers, however. Internalised liquidity, because much of it is not visible to the market and allows buy-side firms to trade anonymously and enjoy minimal information leakage, is only one form of what has been popularly dubbed ‘dark liquidity’. As its providers are quick to emphasise, dark liquidity is neither mysterious nor new, representing an “evolution” of the over-the-counter (OTC) market trading activity that has always historically been ‘dark’, says Goldman Sachs’ Mr Koplin. Today’s dark markets, he says, are simply “electrified and organised”.

As with many of its top-tier peers, including Lehman Brothers, UBS, Citigroup and Credit Suisse, Goldman Sachs operates its own internal dark pool in Europe. In addition, Liquidnet and ITG Posit serve as Europe’s two leading institutional-only neutral dark crossing networks.

Pre-trade transparency exemptions granted under MiFID, however, have given rise to a slew of new dark MTFs, including Euro Millennium, the European counterpart to US dark pool NYFIX Millennium that went live in March; broker-owned Turquoise, which will run a partially dark book; and NYSE’s SmartPool. US provider Pipeline, as well as Swiss exchange SWX, UK exchange PLUS Markets, and the London Stock Exchange, are all planning to launch further UK and European dark offerings in due course, in a trend that is turning even long-established lit markets dark at an accelerated rate.

Useful as dark liquidity might be for dealing in large blocks of shares, the proliferation of fragmented dark liquidity under MiFID is making it increasingly challenging for the buy side to locate available liquidity, as well as to ascertain its depth (how many shares might be available at a given price once that price is discovered).

“The challenge for us is that there is no single point where you can access all of the dark pools,” says Steve Wood, global head of trading at Schroders, a global asset management company that trades on execution venues directly. “We have to go to multiple venues and that’s where you really do need the technology and the [low] latency, otherwise you’re at a disadvantage,” he adds.

One such piece of technology is smart order routing. Widely touted as the panacea for market fragmentation, a smart order router (SOR) is a type of algorithm that is able to automatically route orders to a pre-determined execution venue – ideally, that which offers the best price. But many market participants on both the buy and sell side report that the technology has yet to live up to the expectations heaped upon it. Frequently, SORs fail to discover prices at the required depth, meaning that large orders have to be routed to multiple venues to be filled. As such, the technology ­available has yet to solve the problems represented by ­fragmentation.

Indeed, smart order routing is arguably one of the most over-hyped pieces of technology in the trading arena. Many institutional traders believe the problem should therefore be dealt with at source and that the broker community should make an effort to aggregate parts of their internal dark pools. But these hopes, commercially unappealing as they are, will likely be disappointed.

“Some would say that in an ideal world all stocks would trade in one central limit order book. However, that is just unrealistic,” says Mr Koplin. Instead, “we must try and create a virtual, aggregated solution for our clients”, he says, a task that will yet require some technological advancement across the industry.

In the meantime, however, the problems posed by aggregating hidden liquidity may give way to a further pressing issue: so far, there is no regulatory limit governing the amount of liquidity that can reside in dark pools in Europe. Brian Taylor, a consultant and former CFO at PLUS Markets, fears that the rising tide of dark liquidity in Europe, in that it obscures information relating to supply and demand, will undermine the important process of price discovery. “If the EU market shifts significant volume into the dark pools I do not believe it currently has the regulation to cope with the impact this has on price formation of securities,” he says.

Post-trade trauma

If MiFID has wrought confusion and uncertainty in the pre-trade arena, then its post-trade provisions have proved little short of a failure, says Schroders’ Mr Wood. By fostering competition among trading venues, both independent and internal, MiFID has also driven fragmentation in the post-trade realm, having multiplied the number of platforms upon which both on-exchange and OTC trades can be reported. Importantly, MiFID has also freed up the location in which trades can be reported.

The LSE, Chi-X, and Markit BOAT, account for the vast majority of London-based trading reports, although further venues, in particular Deutsche Börse (historically the European number one) and Euronext, also serve as trade reporting platforms. Competition, as in the pre-trade arena, has vastly increased the complexity of the post-trade arena: this was made clear towards the end of June, when Reuters reported that the combined market share of the top three European reporting venues, LSE, BOAT and Deutsche Börse, dropped to 49.8%.

Many fund managers have been caught unawares by this fragmentation and have, in turn, been incensed by the cost involved in buying back what they perceive to be their own data – the same complaint, of course, that led the sell-side to create BOAT in the first place. However, Markit BOAT charges nearly twice as much as the LSE for its data. Andrew Allwright, business manager of exchange traded instruments at Reuters, says that data costs have nearly doubled in some instances, leading many institutional managers to hold off subscribing to new data feeds. To this extent, many on the buy side only have visibility on a small proportion of the marketplace.

This problem has not been helped by changes made under MiFID to the rules governing trade reporting delays which, in the case of large block trades, can extend to up to three days following execution. As a result, buy-side managers report a fundamental lack of consistency among their brokers regarding the time at which OTC trades are reported. Many practitioners are concerned that this issue, combined with the emergence of new reporting venues, is being exploited in order to disguise large trades. The risk of this type of activity was starkly underlined in February when Montagu Private Equity was able to buy a 10% stake in waste disposal giant Biffa in block share purchases. Due to the new reporting rules, the market did not learn of Montagu’s purchase until the following morning.

More common, however, and of key concern to institutional trade body the Investment Management Association (IMA), is the issue of double reporting in which trades executed on exchange by a broker in order to fulfil an OTC transaction with a client are reported twice. Because there is no agreed methodology on how to report, there is frequently no information in the trade report to suggest the relationship between the two transactions. This serves to dramatically misrepresent the economic activity and interest in a particular stock. Consequently, says SWIP’s Mr Whalley, “We don’t really have a clue exactly what’s going on at the moment – which doesn’t really help anyone.”

This problem ripples through the back office machinery. Transaction cost analysis (TCA), a key performance measurement that, ironically, is actively promoted by the regulators, is being totally undermined by the post-trade confusion.

“If your TCA provider is not pulling accurate data from all of these sources, you’re not really likely to be measuring yourself against the right benchmark or true liquidity available,” says Brian Mitchell, global head of dealing and portfolio control at Baring Asset Management. This impairs the ability of traders to understand market liquidity and, in turn, potential market impact when trading, says Guy Sears, director of the IMA.

For the market at large, however, there is further reason to be wary. The major benchmark indices, as well as the publicly printed information documenting the bid, offer, volume and last traded price of stocks, is also based on incorrect data. If the post-trade situation is not rectified reasonably quickly “confidence in the market, on behalf of the buy side, is going be eroded pretty quickly”, says Mr Wood. To some extent, says Mr Sears, many complaints so far might simply be “teething” problems. But in other areas, particularly on reporting delays, the issue is more fundamental and may only be addressed by proper regulatory intervention.

In a written statement, Oliver Drewes, spokesman for EU internal market commissioner Charlie McCreevy, said: “The MiFID transparency regime is bedding down and time is needed in order to make any overall judgements. The Commission is currently following market developments. The role and the contribution of the industry are important for the day-to-day application of principles and rules, which is consistent, to the highest degree, with the overarching objectives of MiFID.” The European Commission is reportedly to open a two-year probe into equities trade reporting in Europe. But this will take far too long and many in London are now looking to the Financial Services Authority (FSA) for answers.

Although the FSA refuses to comment on the issue, the IMA – which met with the FSA in June to discuss the problem – says that the regulator is looking for a market-led solution, which many participants on the buy side feel is unrealistic. Due to the huge increase in market volatility in recent months, the broker community does not have a vested interest in enhancing transparency, says Mr Whalley, because it will impair their ability to unwind their positions profitably. “Once the markets settle down they will have more interest in increasing transparency as this should increase volumes on a long-term basis,” he says.

The London Investment Banking Association will not speak publicly on the buy side’s complaints. Privately, however, many brokers feel that they are unfounded. “They are trying to take the benefits of a competitive market force without paying the consequential cost of fragmentation,” says one broker. Mr Koplin says, however, that the problems surround post-trade reporting adversely affect sell-side TCA and trading strategies as well.

And not all markets have been adversely affected. In Germany, for example, where post-trade reporting obligations did not exist for OTC trades, transparency is said to have improved. But this is scant comfort to those attempting to operate in London, the world’s most important financial centre. Furthermore, the introduction of new trading venues, due to go live within the next six months, will only expedite fragmentation, creating more confusion and, in turn, undermining MiFID even further.

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