Broker-dealers alone will collectively need to spend a minimum of $700m (€585m) to revamp their trading systems, according to one projection from Accenture.
Yet in truth not even the ‘experts’ know what the total costs on the sell and buy-side will be. It hardly helps that no MiFID-wide/EU-wide cost-benefit analysis has ever been produced. First mover advantage will be key.
Estimates produced by Atos Consulting, indicate that for the UK alone MiFID could cost investment firms, their clients and regulated markets £1.5bn (€2.2bn). But as Bob Fuller, director, IT, at Dresdner Kleinwort Wasserstein and co-chair of the MiFID Joint Working Group, says: “It’s very much crystal ball time” as far as all these guestimates are concerned. Yet with MiFID becoming “increasingly prescriptive”, it can be argued that the costs are more likely to be going up rather than down.
However, until firmer Level 2 detail (expected mid-January, but delayed), the cost impact is hard to quantify. MiFID itself is an extension of 1993’s Investment Services Directive, which created a common passport for trading and open-access across the EU, and consists of four levels. The Lamfalussy Level 2 seeks to finalise the all-important technical implementation measures.
According to the UK’s Financial Services Authority (FSA) “Planning For MiFID” (November 2005): “There are currently no UK requirements about pre-trade transparency as specific as those contained in the MiFID requirements.”
Most of the transparency provisions in MiFID currently cover equities only, but are expected to be extended to fixed income and derivatives. Many already regard the bond market as relatively transparent. The International Capital Market Association with a group of others has commissioned research (soon to be released) into how extending MiFID would adversely affect the European bond market.
Article 65 (1) of the directive requires the European Commission to put forward a review to the European Parliament on an extension of transparency provisions beyond equities. A proposal on derivatives and bonds is expected by around April 2007.
Dr Anthony Kirby, chair, MiFID Joint Working Group (Best Execution & Reference Data Subject Groups), says: “There are market concerns that the majority of this proposal will consist of regulation measures as compared with directive measures – in an approximate 70:30 ratio. This approach is controversial, and belies the designation of MiFID as a straight directive.”
“As things stand, in the blue corner, sit the ‘directive’ measures, which have to be implemented into national law. These are subject to joint interpretation at Lamfalussy Level 3 by each of the member states’ competent regulatory authorities. This leaves the lion’s share of MiFID, in the red corner, to be treated as ‘regulation’ – that potentially has a more direct effect,” explains Mr Kirby.
“The pragmatic view is that MiFID will treat the evidencing of best-execution for instruments traded in both order and quote-driven markets as a series of processes, leaving room for interpretation to firms and national market regulators,” he adds.
Trading transparency
Under the main proposals, traders who trade off their own book in a substantial way will be compelled to publish prices for all their pre-trade and post-trade dealings. This will result in a requirement to store huge amounts of data (prices) and have adequate systems in place that prove investors have been provided best-execution and best-advice, although this may not mean best or lowest price. Mr Kirby says: “There is room for market solutions offered by exchanges to help firms address these issues.”
It is worth noting that the EU does not yet have formal plans for a European best bid offer (EBBO) system in place, and is unlikely to have one when MiFID takes effect.
MiFID too introduces comprehensive pre- and post-trade transparency for trading equities on three main types of execution venues, namely regulated markets (RMs) covering stock exchanges; multilateral trading facilities (MTFs) covering alternative execution venues; and over the counter (OTC) covering trading performed outside the RMs or MTFs.
While the London Stock Exchange and virt-X, part of the SWX Swiss Exchange, both have trading systems and rules that offer transparency ‘tailored’ to the sort of shares being dealt, there are far more extensive pre-trade transparency requirements – especially for trades beneath certain size thresholds and on trades occurring outside the order book.
An entirely new transparency regime is introduced for investment firms that are systematic internalisers (SIs). And, this is where it gets interesting. These are firms that transact deals on account frequently and in an organised fashion by executing orders outside an RM or MTF.
While estimates put the number of SIs at between 50 and 400, not until Level 2 detail is published will it be clear how many there are. The term broker-dealer also has a different definition depending on which EU member state is being referred to. And, there is likely to be a data fragmentation issue as sell-side firms will be compelled to provide firm bid and offer quotes in liquid shares on a continuous basis – but not necessarily via a stock exchange.
The number of venues posting firm quotes under MiFID will rise, which theoretically might lead to greater transparency, but raises a question over whether the buy side and the end asset managers will have full visibility of the market. Investment banks could publish prices on proprietary websites, but they also might want to disseminate such information elsewhere. This could be extremely chaotic, and result in issues for the data vendors wanting to aggregate quotes from a myriad of points.
Holger Wohlenberg, managing director, market data and analytics at Deutsche Börse, has revealed that the exchange has proposed that sell-side firms should “leverage” on Frankfurt’s existing data infrastructure, which benefits from being MiFID-compliant, to avoid a looming fragmentation of pre-trade information.
On the post-trade side, Article 28 requires SIs to publish any trades conducted off-exchange or on MTFs in real time. While not a new requirement, MiFID has expanded the possible venues where brokers can publish prices, for example to market data vendors, proprietary locations and/or proprietary websites.
Dividing the spoils
This opens the door to new initiatives, with some like Octavio Marenzi, chief executive officer of Celent, believing that sell-side firms will want a share of revenues from publishing their data as opposed to being charged by an exchange for publishing it.
The concept or term of best-execution under MiFID is based on firms being able to demonstrate a policy of best-execution across multiple execution venues - currently comprising 25 stock exchanges, 15 derivative exchanges and 15 automated trading systems by today’s figures. Dr Kirby says the term under MiFID as it stands means “different horses for different courses, with scope for cross-breeding”.
“Costs, value, speed of execution, market impact, opportunity cost and credit-worthiness are just some of the factors that firms consider when delivering a superior quality of execution in more liquid markets. However, relatively illiquid or highly specialist markets such as certain structured products may well need to rely on a “best efforts” basis, especially if price comparability is impaired. Market realities will need to be balanced with client expectations and instructions,” says Dr Kirby.
Data will be key under MiFID – as with RegNMS (regulation national market system) in the US – if not more so under the latter. If the quality of a firm’s execution is open to doubt or challenge, then firms will need to invest in recording the circumstances and building in the relevance of the factors at the time to mitigate disciplinary action. In the US, the Securities and Exchange Commission (SEC) formalised its best-execution definitions for equities as far back as 2000/2 on the basis of “best terms”.
“RegNMS and especially MiFiD could presage the fall of the one-size-fits-all approach to best execution,” Mr Kirby argues. (Neither RegNMS nor MiFID applies extra-territorially, so the influences of each on the US and European exchanges and markets will be indirect).
There are also specific references to the costs, which are directly related to execution of the order under MiFID including exchange fees, settlement fees, and indeed any other fees paid to intermediaries involved in the execution of the order, plus the commission charged to the client by the firm. In order to comply with Article 21 (2), investment firms must not use their own commissions to discriminate between execution venues.
The MiFID Joint Working Group’s (JWG) Best Execution Subject Group has expressed concern on this issue, since according to Mr Kirby “the inclusion of commission into the best-execution measure introduces self-referenceability into the mix”.
Best-execution should be “delivered on the basis of searching for the best price and the economics of achieving the same, with each party working out its own profitability”, says the JWG.
On execution venues, the MiFID JWG also has concerns about how firms would maintain lists of each and every execution venue, or how execution venues such as exchanges and MTFs could possibly provide consistent data relating to execution quality without agreed market practices.
Investment firms are required to publish their order execution policies and regulators in each member state are tasked with reviewing each firm’s adherence with their stated policies. This assumes that the regulators have the core competencies and the resources to fulfil these functions in every member state.
How exactly firms will take “net” consideration – the price of the financial instrument and the costs related to execution – into account when executing a trade for a retail investor is open to interpretation.
“Our current understanding is that firms must provide evidence that best-execution was realised when called to do so – for any asset class with the caveats above, irrespective of whether the market functions as an order-driven or quote-driven one. Best-execution is treated as a process, whose approach draws heavily from both the existing SEC and the FSA definitions,” adds Mr Kirby.
At present, the EU does not have formal plans for an EBBO system in place, and is unlikely to have one when MiFID takes place.
Punishing laggards
However rocky the road to MiFID’s current implementation date of 1 November 2007, some firms will be ready in advance while others will miss the deadline altogether. But given the persistent implementation delays, will the politicians in Brussels have the clout to come down on those failing to comply?
Those wishing to get more acquainted with the whole area could do well to view “MiFID Revealed”, an educational DVD produced by CityCompass Research, before matters get even more complex. Latest conjecture is that best-execution be will be directives-based (blue corner) as opposed to regulation (red corner).
