Seeing through transparency

The improved transparency promised by MiFID II may end up exposing the buy-side's positions in less liquid stocks, making risk trades even riskier for brokers and more expensive for the buy-side.
By None

Will the increased transparency promised by MiFID II be welcomed by the buy-side?

Not entirely. In some cases increasing transparency threatens to increase the costs of trading. Information leakage increases market impact and where regulation seeks to increase transparency, it can expose previously hidden information. A good example of this is the proposal to reduce trade reporting delays from the up to T+3 as they currently stand, to the end of day, or at least the start of the following trading day.

Why are the regulators proposing to shorten the reporting delays?

A significant aim of MiFID II is the provision of reliable, timely and accessible pre- and post-trade data. The fragmentation of European equity market liquidity caused by MiFID required market participants to aggregate post-trade data published at different frequencies and in a range of formats by trading venues.

In its MiFID II consultation paper, released on 8 December, the European Commission (EC) stressed that the transparency of post-trade information is important for efficient price formation and to assist buy-side firms in analysing execution performance by tracking comparative execution prices across trading venues and brokers.

It said that many supervisors and market participants agreed that the maximum permitted delays should be reduced, which would help to make post-trade information available to the market sooner.

What effect could this increased transparency have on the cost of trading?

By shortening the timeframe for reporting large trades from T+3 to the next or same day, firms that wish to unwind a position will have less time to do so. Failure to do so increases information leakage, market impact and ultimately cost. Counterparties, particularly firms that look for opportunities to take the other side of a position, such as high-frequency trading firms, will have more up-to-date information on which firms are unwinding positions and will be able to exploit that knowledge more readily.

What kinds of trades are most likely to be affected?

The most obvious are those executed by brokers that have taken on risk trades from clients. By taking on and then unwinding a position on behalf of a client, a broker can charge a premium to compensate for the additional risk it is exposed to. Under current reporting rules, market participants are allowed three days to unwind a large position before the broker's exposure is reported. If this is reduced to end of day, or beginning of the next, a broker's risk would be increased and it may have to increase the charge for taking on risk trades for buy-side clients. Buy-side firms are more likely to have difficulty unwinding positions in illiquid stocks such as small- to mid-caps; an increase in trading costs that could reduce returns and diminish investment appetite on the longer term.

What efforts are being made to have this proposal changed?

Responses to the EC's consultation paper submitted in February 2011 warned of these risks; the Investment Management Association, a UK buy-side industry body, said in its submission, “anecdotal evidence from the US suggests that the premium demanded for risk pricing increases by approximately 50% from the morning to the afternoon because the risk transfer must be reported at the end of the day.”

Individual buy-side firms have also supported their representations to the EC with empirical data. However Laurent Degabriel, policy officer for securities markets at the EC, later said that transparency would override all other concerns when developing the regulation.

With the EC's MiFID II proposal now expected to be delayed until Q3 2011 at the earliest, there is still time for firms to make their case in a more convincing manner. However some asset managers and brokers say they are prepared to swallow higher costs for the sake of improved transparency.

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