Chris Skinner reviews the new European legislation aimed at protecting the buyer by ensuring transparency on off-exchange trading of equities, equity derivatives and money markets.

The European Union is undergoing a radical programme of change to achieve the vision laid out in 2000 of becoming “the most competitive and dynamic knowledge economy in the world” by 2010. As part of that vision, the European Commission has introduced a wide range of legislative changes to the financial markets covering all aspects of banking and insurance.

One such legislative instrument is the source of increasing concern for the investment banking community – the Markets in Financial Instruments Directive (MiFID), which some believe is more fundamental and disruptive to the investment community than Basel II and Sarbanes-Oxley combined.

MiFID is in its final phase of drafting by the Committee of European Securities Regulators (CESR), with a deadline of April 2007 for implementation. The purpose of the directive is to ensure protection for the buy-side and consumers by enforcing best execution principles on the sell-side. It achieves this by providing a common set of rules for pre- and post-trading transparency, which are meant to protect consumers from harming themselves with complex instruments such as derivatives.

Off-exchange trading

The issue the directive seeks to address specifically is off-exchange trading. The historical bank activity of trading equities and other instruments off their own account has been a great source of risk and reward for both buyers and sellers. It is the risks in that trading that MiFID is addressing by forcing the sell-side to publish all their prices for all their dealings in the public domain, and those prices have to be published and kept up to date on an ongoing basis during working hours. This is initially just for equities, equity derivatives and money markets from April 2007, but will cover all financial instruments over the next few years.

So far, so good. However, this is not necessarily good news for either party. The sell-side in particular is concerned.

“There are immediate implications for how financial services firms manage their research, execution, client and market dealings,” says PJ DiGiammarino, head of customer-facing technologies at Barclays Capital. “For example, all European investment banks are likely to be classified as systematic internalisers under the directive.”

A systematic internaliser is defined as an organisation which “on an organised, frequent and systematic basis, deals on its own account by executing client orders outside a regulated market or an MTF (multi-lateral trading facility)” for more than 15% of their total volume of transactions in that line of business. This criterion will mean that all investment banks are likely to be systematic internalisers for all their traded products.

Best execution

So, what are the implications if you are a systematic internaliser? Well, the core issue is that you have to publish all of your prices on all of your products in real time in the public domain. Secondly, you have to store your prices and those of all other firms dealing in those instruments throughout the day. The reason for the latter is that you must be able to prove you delivered best execution at the time of a trade – ie, you gave the client the best price available.

That is a massive change to the way the industry has historically operated and has huge implications for the structure of trading rooms, sales and marketing organisations, their processes, their technology and the data that they rely on.

“MiFID means that we will have to take a cross-asset class approach to doing business,” says Bob Fuller, head of IT strategy at Dresdner Kleinwort Wasserstein. “A cross-asset class approach means real change to how you know the customer, treat them fairly and prove you know the status of the market at all times.

“You will also need to change business strategies, processes, roles and responsibilities, applications, data and IT infrastructure to cope with the new pre- and post-trade requirements. The timing is very tight and a holistic approach to implementation is required.”

Practical difficulties

Why does this mean such a big change? In practice, anyone wishing to fill a customer order will now have to supply, in writing, a list of all the ‘execution venues’ supplied to them. Execution venues are all the places you could send the customer’s order for execution such as regulated markets, MTFs, other systematic internalisers and so on. This is because an exchange price is no longer considered to be the only or best market price.

When the customer places their order and asks for “best execution”, the law will now state that you must prove, for the value and volume of the order placed, that you give the customer the best price available from those execution venues at the time of the trade. Also, the seller must be able to prove that orders are executed in the order they are received. This is not an easy task when you have a mix of voice, electronic and trader-generated order communications.

Furthermore, if you are trading off your own account, the price you quote must also be made public and cannot be altered from that public price.

Tight timing

The question most firms are asking is how to ensure they give the best price against all the market players trading in an instrument at every micro-second of every working hour? The answer for many is that this can only be achieved through automated trading tools, such as order management systems linked through to programme trading applications. This implies that dealers and traders have the most to lose, as MiFID will drive many organisations to automate the whole thing using programme and algorithmic trading tools, as exposure to breaking the rules is increased dramatically when a human is involved.

Importance of IT

It will also mean that the role of IT will become even more important. “There will be some ability to further reduce costs by offshore outsourcing, but it is hard to do. MiFID will force an increase in IT budgets over the next three to five years. That will be a real challenge to the businesses as other regulatory initiatives are already soaking up most of the budgetary capacity today,” says Mr DiGiammarino. “There are also significant implications on labour supply and many of the technology dependent business plans in place today will need to be deferred. There is an enormous opportunity cost that has yet to be quantified.”

The consulting firm ATOS Origin estimates that, in the UK alone, MiFID will cost more than £1.5bn to adapt technology, systems, processes and structures, and a number many times that amount in lost business and opportunity costs.

Possible pluses

That does not mean there are no opportunities in the MiFID implementation. For example, firms will be able to provide services throughout the EU under a single licence in their home country. That avoids having to re-register for trading in every European country and allows much greater cross-border competition. In addition, the ‘concentration rules’ that dictated that all trades had to take place on the exchange are now removed, making it easier to do business.

However, the overall costs of MiFID appear to be far greater than the opportunities and the key to creating the infrastructure to manage this challenge could be industry collaboration. Is this possible in an industry that has not seen collaboration on a broader scale?

“Other industries have proven that collaboration is possible,” says Mr DiGiammarino, “and it is hard to see how the larger firms will not act together to aggregate their infrastructure capacity, either though collaboration or acquisition. The smaller firms are definitely exposed. They will need to move quickly to determine their role in the new value chain.”

“The result is that the political landscape within and between firms will be radically altered,” says Mr Fuller. “With increased costs per trade, margins in already competitive markets will shrink and may cause firms to exit entire lines of business.”

Whatever the position of an organisation, if it is not considering how to understand, adapt and implement MiFID, it will find that this directive will creep up and potentially wipe out its traditional book of business.

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