The European Commission (EC) has delayed releasing details of its MiFID II proposals until Q3 2011, but will there be any major surprises?
That's unlikely. The unwavering message from Brussels is that MiFID II must improve transparency in Europe's financial markets. For example, Laurent Degabriel, policy officer for securities markets at the European Commission, said at the TradeTech Europe 2011 conference in April that the EC's commitment to transparency was its primary focus in revising MiFID.
Politicians and regulators want to reduce the risk and cost that opacity can create. As such, a major target is the off-exchange or over-the-counter (OTC) markets for trading derivatives and equities.
Why are politicians so keen to shine a light on the OTC market?
The default of Lehman Brothers in 2008 left many market participants struggling to identify who was or wasn't exposed to the collapsed US bulge bracket broker because much of the OTC market for credit default swaps was managed with very little oversight, central record keeping or paper trails. The cumbersome manual processing of many derivatives trades meant unwinding the positions was slow, so it took a long time to work out who was exposed and by how much.
The broker's collapse also demonstrated the lack of regulatory oversight. At their Pittsburgh Summit in September 2009, leaders of the Group of 20 countries set out a framework for economic growth based on “propriety, integrity, and transparency”. As such legislators and regulatory bodies are now working to implement the details of this framework into the rules that govern their markets.
How does this affect the equity market?
A lack of transparency gummed up the credit and money markets globally after Lehman collapsed. Interbank rates soared because no one knew for sure the extent of banks' exposures to sub-prime mortgages and as such, only lent at steep premium. Since then, transparency is being held up as the guiding light for all financial markets regulation.
More specifically, competition introduced by MiFID in 2007 fragmented the European equities market, pushing a lot of trading onto new venues. How much meaningful trading activity is actually now traded off-exchange is hotly debated, not least because of a lack of consistency in reporting.
“We can state that MiFID – as intended – led to more market fragmentation and competition between trading platforms. When it comes to transparency, we cannot say that MiFID worked out well,” Markus Ferber MEP, the rapporteur for the European Parliament's MiFID II rules, observed in the Q2 2011 issue of The TRADE.
The concern that MEPs have is that increased rates of off-exchange trading damages price formation on primary exchanges, a process already made more complex by market fragmentation.
A paper written by Kay Swinburne MEP in July 2010, which was passed by the Parliament in November, suggested that an order size limit should be imposed on dark trading venues to drive smaller orders back onto the lit markets and that trading venues that do not have a regulated status should be looked at for reclassification as multilateral trading facilities.
How will the proposed MiFID II rules make the markets more transparent?
When Michel Barnier, EC internal markets commissioner, launched the MiFID II consultation on 2 February 2011, he gave the example of crossing networks and high-frequency trading firms as businesses that need to be more transparent, in order that regulators know “who's doing what and to whom”.
In addition to its proposals on dark pools, the EC's consultation paper suggested two means of improving transparency. The first is to standardise the reporting of trades, the second is to create a single tape on which they are reported.
Standardisation of reporting would remove the problem of double counting, for example, which currently makes it harder to correctly judge the size of the OTC market. It would also allow firms to build an accurate picture of execution performance compared to their peers.
The single post-trade tape for all European equities transactions would also help to remove the challenge posed to price formation by the fragmentation of price data across multiple markets.
This all sounds reasonable …
… Yes, until you consider that trading by institutional investors is achieved most effectively by hidden intentions.
By reporting trades in close to real time, practices like risk trading could be made impractical. Risk trades allow buy-side firms to pass a large position onto their broker, for a premium, so that the broker bears the risk of accumulating or unwinding the position.
Currently large trades can be reported up to three days after they are made, giving the broker time to get rid of or rebuild the position acquired via a risk trade.
If the reporting time is shortened to the start of the following day, as is proposed, their position will be exposed very shortly after it is taken on. That increases the risk of market impact, and the associated costs. Transparency could end up costing the buy-side trader more.
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