Improving technology to deal with regulatory change is high on everyone’s agenda across all asset classes, but to what extent will the impact be felt in equities?
When thinking about equity trading, MiFID II is probably the first thing that comes to mind, but this is mainly a sell-side concern.
For buy-side firms, the current trading environment, characterised by low volumes across fragmented markets and dwindling commissions, requires a reassessment of where they should direct their orders and overall spending.
Having less commission to play with means the buy-side will have to exercise a greater degree of scrutiny when deciding who to trade with. Budgets may be falling across the industry, but spending now may yield long-term efficiency gains.
What tools do institutional investors need to improve efficiency?
The focus here should be on transaction cost analysis (TCA) and management of commission sharing arrangements (CSAs).
Regarding TCA, having enough quantitative data to assess execution performance will allow the buy-side to make a better assessment of the brokers and venues that are delivering the best results, as well as reminding counterparts that their performance is being constantly monitored.
By making greater use of CSAs and related broker voting technology, buy-side traders will be able to split commissions between execution and research providers more accurately, reflecting the value they are getting from the sell-side and hopefully reducing bills too.
And all this before we’ve even considered the potential investment that may be required from MiFID II?
MiFID II won’t be as cost-intensive as the first version, but will require brokers to reinvest, or risk being left behind.
The provision of electronic execution tools skyrocketed since MiFID was first introduced in 2007 and the asset class is now considered to be the most advanced from an execution standpoint.
Interesting to note that the European Commission, in its initial October draft of MiFID II, placed the total costs of complying with the updated directive at between €824 million – €1.32 billion, which it said were far less than the costs associated with the original legislation.
Where are the most significant costs of MiFID II likely to fall?
Taking into account the European Commission’s original draft and the first round of amends submitted by Parliament, operators of dark pools and providers of algorithms – basically the sell-side – could face added costs.
A particularly contentious debate is the tightening of the rules governing broker crossing networks (BCNs), with some market participants arguing for a regulatory framework that is closer to other types of trading venue. The Commission used MiFID II to create a new regulatory framework for BCNs, termed the organised trading facility (OTF).
Those brokers that find the OTF requirements do no match up with the service they want to provide – such as the current proposal to prohibit in-house flow in BCNs – may have to launch a separate multilateral trading facility or systematic internaliser, adding substantial costs.
The further fragmentation of dark pools is largely expected by the industry, with an increasing number of companies – such as Cinnober, Forum Trading Solutions and Quote MTF – punting technology that supports MiFID II-compliant trading venues.
More trading venues also means more investment in technology that optimally sources liquidity across the different types of markets, adding further cost for brokers and their clients.
This sounds like it could cost brokers quite a bit. How do potential new rules on algorithms compare?
MiFID II, combined with recent guidance from the European Securities and Markets Authority (ESMA), will require brokers and trading venues to install better oversight and risk controls. The overhaul of surveillance systems to help brokers comply with the ESMA guidelines will require brokers to fork out €113 million this year alone, according to estimates from TABB Group.
Does MiFID have a buy-side impact?
One cost for the buy-side will come when the industry finally solves the long-running problems of the consolidated tape for equities.
MiFID II currently favours a commercial approach to the creation of a consolidated tape, allowing multiple providers to compete based on pre-defined data standards. The tape has always been seen a must-have, rather than a nice-to-have, by most buy-side firms that want a better idea of how trading occurs across fragmented stocks.
But a number of the MiFID II proposals related to its formation, such as ensuring exchanges do not overcharge for their data, are positive for the buy-side and are likely to make what most see as a necessary utility for equities trading as cost efficient as possible.
Moreover, the longer-term benefits of the consolidated tape with outweigh the short-term costs, as the buy-side will have a tool that helps them to better seek best execution and monitor broker performance.