It is hard to believe that a dry-sounding European Commission directive that came into force almost exactly two years ago could have had the effect on Europe’s equities markets that it has.
But the Markets in Financial Instruments Directive (Mifid) has resulted in some astonishing changes to the trading landscape – probably far beyond what its architects envisaged.
The idea was to spark competition in share trading by ending the monopolies of the continent’s big exchanges – the London Stock Exchange, Deutsche Börse and Euronext – and allowing the emergence of new platforms, such as Chi-X Europe.
Fees would be forced down, lowering transaction costs and thus barriers to entry for millions of investors across Europe while at the same time bringing the region’s capital markets more in line with the US, which has long had a cost advantage.
Purely on this level, Mifid has been a resounding success. Chi-X Europe, one of five similar “multilateral trading facilities” (MTFs) to have sprung up to challenge the exchanges, has captured around 22 per cent of trading in FTSE 100 shares.
In addition, it also routinely ranks as continental Europe’s third largest exchange by turnover of contracts. Its pan-European share offering – involving 14 European indices – puts it ahead of the Bolsa y Mercados Españoles, the Spanish bourse, and on some days even ahead of Deutsche Börse.
In response, fees have fallen sharply on the LSE and other exchanges.
However as the European Commission prepares an in-depth review of Mifid, there are some who think it had unintended consequences.
Sébastien Jaouen, head of trading community services in the trading services division of Orange Business Services, a trading technology company, says: “The initial promises and objectives of Mifid were twofold. First and foremost to increase transparency for all market participants, whether professional or individual investors. Second, Mifid aimed to break the historical exchange monopoly to lower the total cost of transactions. On both issues the results are mixed at best.”
The fragmentation of liquidity across many venues is making it hard for investors to know whether they are getting the best prices for their deals. While Mifid requires brokers to achieve “best execution” for their clients – typically so-called “buyside” investors like asset managers – Mifid never spelled out how to achieve best execution. The result is that brokers write their own best execution policies, which may differ from one to another.
One broker says: “It’s deeply embedded in Mifid that the regulators set the tone, while the market will come up with the solutions. But I think the market needed a stronger steer.”
This has led to increasing pressure from the buyside on brokers to demonstrate their trading technology – like “smart order routers” – is doing all it can to ensure that not only the best prices are being achieved across Europe’s multiple MTFs and exchanges, but also that the most efficient post-trade solutions are being used as well.
And with grading moving at rapid speeds, the need to “benchmark” brokers is getting to the point where it is almost needed in “real time”, throwing up opportunities for specialist trading technology companies.
Quod Financial, one such company, plans to launch a “smart broker routing” service next year that will automatically rank brokers’ performance by how much they charge for trades and whether they get the prices.
Another issue is “dark pools”. While Mifid was all about competition, it was drafted at a time when many of the complex algorithmic trading strategies that are now common and are used in dark pools did not exist.
Dark pools are supposed to be platforms where large blocks of shares are traded, away from the public order book of an exchange, with prices posted only after trades are done.
Yet industry experts say many of the 15 or so dark pools that have sprung up in Europe in the past two years are actually being used to carry out small tranches of shares, often by algorithmic or so-called “high frequency traders”. This is something regulators will need to grapple with, as they scrutinise dark pools.
Dark pools are emerging as a source of friction between exchanges and banks that operate their own dark pools, also known as “crossing networks”.
Two months ago the Federation of European Exchanges (FESE) launched an attack on crossing networks, arguing that they were not properly registered under rules laid out by Mifid.
FESE argued in a letter to the Committee of European Securities Regulators that the growth of activity on crossing networks meant that Europe was becoming a ”dealer market”.
The banks hit back, saying their dark pools provide a legitimate service to institutional investors and provide liquidity to markets.
The Committee of European Securities Regulators is looking at the issue and is expected to feed its findings into the European Commission’s overall review of Mifid.