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A conference for equity trading executives and institutions in Barcelona last month was dominated by debate over the introduction of Mifid II, the vast overhaul of European markets that comes into force on January 3.
The audience was made up of specialists who, for the past seven years, have been painstakingly engaging with regulators and policymakers over the EU directive.
Yet even among these experts, uncertainty abounds about the likely effect of the new regime.
“Basically, as a collective industry, right now we just don’t have a clue,” says Steve Grob, director of strategy at Fidessa, a UK trading technology company.
Few professionals ought to have a better insight into the 1.5m paragraphs of regulations. These are intended to increase competition and transparency and shore up investor confidence, which was so bruised by the 2008 financial crisis.
Nevertheless, Mr Grob’s comments reflect the fact that the legislation is likely to be less of a Big Bang and more of a big leap . . . into the unknown.
The review of Mifid, properly called the Markets in Financial Instruments Directive, seeks to move a significant part of over-the-counter trading on to regulated trading platforms. This will affect how prices are set and trades are executed and recorded.
“It will be significant and can’t be understated,” says Verena Ross, executive director of the European Securities and Markets Authority (Esma), the pan-European regulator.
Mifid II will supersede the first version of Mifid legislation of 2007, which aimed to be a cornerstone of EU efforts to create a single financial market for the bloc by ending the monopoly of stock exchanges and driving down overall share trading costs for investors.
The financial crisis, however, exposed its narrow focus on equities while the advent of high-frequency trading made some of the rules appear out of date.
Some aspects of Mifid II are high profile, for instance, the targeting of potential conflicts of interest in the way asset managers pay brokers for research: already some analysts fear for their jobs as fund managers cut back on research from brokers and banks. Others are arcane, such as ensuring that clocks inside trading computers are synchronised to a universal clock.
Part of the problem is that the revised EU directive, agreed in 2014, was broad and relied on Esma to draw up complex and extensive technical standards that turned general legal principles into practical, workable rules for markets.
Even now, though, it is unclear what some of the standards mean. “There remain so many areas where interpretation is unclear,” says Damian Carolan, a partner at law firm Allen & Overy. “It’s only once we see the behaviour in practice we’ll see interpreted decisions become more visible.”
The number of paragraphs contained in the Mifid II directive
Even the regulators admit to shortfalls. “There is still a question about primary law and what it means and how it’s interpreted, and at this stage we shouldn’t be having the debate. This is not good,” admits Tilman Lüder, head of the securities market unit at the European Commission.
The uncertainty is particularly acute in equities. Mifid II, as part of its push on transparency and conflicts of interest, wants to limit the amount of trading that banks can do in-house in matching deals between their customers.
Its regulations will also restrict the amount of trading done in off-exchange venues known as dark pools. About a tenth of all European market trading takes place off-exchange.
Executives say they cannot predict how the regime will unfold.
The proportion of European market trading occurring off-exchange
“There’s a surplus of bank trading desk volume that will be looking for a new home somewhere,” says David Howson, chief operating officer at Bats Europe, one of the region’s largest stock exchanges.
In the short term, Mr Howson expects big blocks of trades to move to exchanges that cater for the waivers that regulators granted to investors executing large deals.
He acknowledges that this uncertainty over the bank’s trading volume may be shortlived. Banks are still wary of sending trades to an exchange where they would have to pay millions of euros in trading fees.
“If it all goes on exchange, the cost goes back up for investors,” says the head of trading at one broker.
Executives are wary about the impact of one solution: to trade for customers on their own account, banks and high-frequency traders can register as a “systematic internaliser”. This is more lightly regulated than an exchange. For high-frequency traders, it may open the door to more business from asset managers.
It is unclear, though, how many banks and high-frequency traders will sign up to attain the status, or how they will interact with each other. Regulators have tried several times to rewrite the words to prevent even more shares being traded off-exchange than before the rules came in. Banks and high-frequency traders will not even need to register formally until September next year because Esma has to assess data collected under Mifid II to make a judgment on each institution’s behaviour.
Similar ambiguities of interpretation hang over the fixed income market. The rules intend to inject more transparency and competition into the pricing of deals, putting them on to electronic venues and, where possible, giving purchasers a greater choice of quotes.
That worries some investors and traders because bonds and capital swaps are far less liquid than shares and displaying a possible intention to trade could move the price of the instrument against the buyer.
As a result, some market participants and venues are interpreting the law to mean that it would be permissible to negotiate privately or arrange a deal by phone — and only then transact on a screen and report it afterwards.
Esma will review which bonds and derivatives should be quoted transparently on screen but they will not be updated until 2019. “People will feel the effects of Mifid II but only after 18 months,” predicts one executive, who declined to be identified.
“That’s the problem with market change — the impact gets overestimated in the short term but underestimated in the long run,” says Mr Grob.