A proposed reform of MiFID could have a major impact on the OTC derivatives market, and it has been suggested that the authorities are paying only lip-service to consultation.

What is it?

On December 8, 2010, the European Commission (EC) published a consultation on the revision of the Markets in Financial Instruments Directive (MiFID) of 2007.

Why have a review?

To address developments since MiFID's implementation and respond to post-crisis concerns on investor protection, regulating over-the-counter (OTC) trading and oversight and transparency of commodity derivatives markets.

What are the main provisions?

The review has morphed into a full reassessment of market structures in the EU, with a focus on pushing transparency in every aspect of the traded markets. The proposed changes are particularly dramatic for OTC markets. Besides data consolidation, transaction reporting, investor protection, the removal of options and discretions and access for third-country firms to EU markets, it includes:

- a new category of trading venue – organised trading facilities – capturing all manner of discretionary and non-discretionary, bilateral and multilateral methods of trade execution in equities and non-equities. Broker crossing networks will be exposed to significant new requirements;

- OTC derivatives subject to clearing obligations under the European Market Infrastructure Regulations that are sufficiently liquid will have to be traded on exchanges;

- pre- and post-trade transparency rules will be extended to equity-like instruments and non-equity markets;

- there are new requirements for commodity derivatives exchanges and fewer exemptions for commodity traders;

- reinforced supervisory powers include the ability to ban products and practices, and to set position limits.

What's in the small print?

The accelerated timeline. The deadline for comment is February 2, but the EC plans a formal proposal by the second quarter, leaving little opportunity to digest comments. "The tight timescale suggests that the proposals are set, and that the review only pays lip-service to the notion of industry consultation," says one industry participant.

What does the consultation say?

"As part of the consensus under the G-20 to tackle less regulated and more opaque parts of the financial system, significant extensions are required in MiFID as regards the organisation, transparency and oversight of various markets segments, especially in those instruments traded mostly over the counter... The EU has committed to minimise, where appropriate, discretions available to member states across EU financial services directives."

What does the industry say?

According to law firm Allen & Overy (A&O), the increased powers and data available to regulators will give them unprecedented knowledge and power, but the impact on trading venues and brokers and investors is unknown. "The impact on service providers – from new authorisations to policy revisions, IT build and customer repapering – may well be significant. The extent to which investors will feel resulting benefits in practice, and at what cost, is much less clear," says A&O's client review.

The MiFID review calls for mandatory trading of "sufficiently liquid" OTC derivatives, but offers little guidance on the liquidity threshold. "Setting the right level could be difficult," says Damian Carolan, a partner at A&O.

Many market participants fear that the ability of the new, Paris-based European Securities & Markets Authority (ESMA) to ban products and activities will kill even sensible innovation. "This is a terrifying new power," says one banker. "Any product ESMA doesn't like the look of, doesn't understand or which doesn't easily fit into the trading and clearing model the review sets out, could be banned or capped. The day that this power is exercised will be a dark day for financial markets across Europe."

The law of unintended consequences

"Bringing a whole range of equity-style regulation into non-equity markets is heavy-handed and could have unintended consequences – from the adverse impact on liquidity that pre-trade transparency might cause to the extended concept of 'admission to trading', which potentially triggers the application to pure OTC instruments of various EU legislation designed for listed securities," says Mr Carolan.

Could we live without it?

Nobody objects to ongoing review of MiFID, nor to tweaking of the directive. The fear about this review is that it is being rushed through with too little thought about the potential consequences.

Rage-ometer

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