The European Commission (EC) has officially adopted its long-awaited MiFID II proposals, which it says will increase transparency, lead to more robust market infrastructures and take account of technological innovation in financial markets.
The new MiFID is accompanied by a separate regulation – termed MiFIR – which, unlike the directive, will not permit interpretation of the new framework at the national level.
The impact of the original MiFID legislation, which introduced trading venue competition and enshrined best execution principles in European securities markets in 2007, was always intended to be reviewed by the Commission. But the global financial crisis sparked by the collapse of US sub-prime mortgage markets and the failure of Lehman Brothers, the US investment bank, has widened the scope of the reforms considerably.
“Financial markets are there to serve the real economy – not the other way around. Markets have been transformed over the years and our legislation needs to keep pace,” said Michel Barnier, the European commissioner for internal markets and services. “The (global financial) crisis serves as a grim reminder of how complex and opaque some financial activities and products have become. This has to change. Today’s proposals will help lead to better, safer and more open financial markets.”
BCNs under pressure
One of the most substantial changes to MiFID will be a tightening of the rules governing broker crossing networks (BCNs), which will be formally recognised for the first time under a newly-created organised trading facility (OTF) regime.
“The objective is to put an end to the reign of the over-the-counter (OTC) trading platforms and ensure that pre-trade transparency requirements are only waived under limited circumstances,” said Barnier during a press conference today.
OTFs will also incorporate new over-the-counter derivatives trading venues required by Group of 20 requirements for the reduction of systemic risk in OTC derivatives markets. Clearing and reporting rules for OTC derivatives trading are expected to be finalised in the European market infrastructure regulation (EMIR) by the end of this year.
Under MiFID II, BCNs will no longer be able to contain proprietary trading flow, but they will retain the control they have over how executions take place.
“While both the rules on access and execution methodology of an OTF have to be transparent and clear, they allow the operator to perform a service to clients which is qualitatively if not functionally different from the services provided by regulated markets and multilateral trading facilities (MTFs),” read the EC proposal.
BCNs will also be subject to the same pre- and post-trade transparency requirements as regulated markets and MTFs, which means they will have to report executions in real time.
Broker’s internal crossing engines fall outside the trading venue structure established by MiFID In 2007 and have been the subject of fierce debate between exchanges and brokers. Brokers view BCNs as part of the overall execution service provided to the buy-side, while exchanges view them as creating an uneven playing field among European execution venues.
The EC will also adopt proposals that could force market making algorithms to be operate continually during market hours. The directive is expected to state that algorithmic strategies must post quotes at “competitive prices with the result of providing liquidity on a regular and ongoing basis… regardless of prevailing market conditions”. The proposal has raised concerns that the high-frequency trading firms that deploy high-speed market making algorithms may withdraw from the European market rather trade in potentially unprofitable circumstances, thereby reducing valuable liquidity.
Investment firms that use algorithms could also be required to detail the nature of strategies and risk controls to national regulators on an annual basis.
Under the directive, national regulators will be required to monitor trading venues’ systems, direct access risk management procedures, co-location fees and access and the circumstances under which trades are cancelled or trading halted.
In addition, “stricter checks will be imposed on arrangements whereby members of trading venues allow other firms employing high-frequency algorithms to access public markets through their systems”.
Furthermore, regulated markets would have to inform other MTFs and OTFs in the event that trading in a particular instrument is halted. The MTFs and OTFs would also be required to halt trading in the affected instruments unless there is a good reason not to.
In terms of the delayed reporting of trades, MiFIR will let national regulators decide when trades are eligible for deferred publication based on their type or size.
The regulation will state that trading venues “shall obtain the competent authority’s prior approval of proposed arrangements for deferred trade-publication, and shall clearly disclose these arrangements to market participants and the investing public”.
The EC will use delegated acts that will accompany MiFIR to detail the overarching criteria for trades that qualify for delayed publication, effectively giving national regulators a framework to work within. Pan-European securities watchdog the European Securities and Markets Authority (ESMA) will be responsible for monitoring how trade reporting delays are applied and provide an annual report to the EC on how they are used in practice.
While the latest proposals do not explicitly reduce trade reporting delays, buy-side participants have expressed concern at the potential for a less harmonised approach if national regulators are given too much flexibility.
Opening Europe’s infrastructure
The accompanying regulation to MiFID II also tackles access to central counterparties (CCPs) by trading venues to foster post-trade competition. Under MiFIR, CCPs shall be required to clear financial instruments on a non-discriminatory and transparent basis, regardless of the trading venue on which a transaction was executed. CCPs will also be unable to discriminate on fees imposed on trading venues that want to access them. The same access rules also applies to CCPs that want access to trading venues.
Access to market infrastructures is also tackled in EMIR, the scope of which is currently restricted to OTC derivatives from a clearing perspective. MiFID II makes explicit reference to EMIR, dictating that MiFIR’s requirement will not apply to any derivatives that are already subject to the access obligations under EMIR.
According to the Commission, the new framework introduced by the regulations “will ensure that new providers can compete for the provision of trading or central clearing services and full price transparency at each level of the post-trading chain.”
However, a late-stage draft of MiFID II asserted that organisations can be denied access to market infrastructures because of “other factors creating undue risks” – a phrase which market participants have argued could be left open to broad interpretation.
The final MiFID II draft will also introduce new index licence requirements, which assert that trading venues “should not be able to claim exclusive rights in relation to any derivatives subject to this obligation preventing other trading venues from offering trading in these [index and benchmark] instruments”.
Europe’s consolidated tape
As expected, MiFID II shows that the Commission favours a commercial approach for creating a consolidated tape of post-trade data across Europe’s securities markets. The introduction of a consolidated tape will allow the buy-side to benchmark their executions more accurately and obtain an accurate picture of where European liquidity lies.
The quality of data will be managed by approved publication arrangements, entities that will be required to clean data so that it is suitable for standardised consolidation. Consolidated tape providers would be under strict criteria relating to how each trade should be tagged.
Best ex revisited
In a bid to bolster the best execution regime, which the EC has described as “standard and generic”, sell-side firms will be require to make public the top five execution venues they use for client orders on an annual basis.
To protect investors, ESMA and national regulators will have the power “to ban specific products, services or practices in case of threats to investor protection, financial stability or the orderly functioning of markets”.
The Commission predicts that the MiFID review will impose one-off compliance costs of between €512-732 million and ongoing costs of between €312 and €586 million per year for the European banking sector.
Now that the EC’s proposals have been finalised, MiFID II will now be debated separately among the European Parliament and Council of the European Union, with both required to jointly agree on a final text before implementation.