Uunderstanding the known unknowns of MiFID II will be critical, Joseph Mariathasan warns
Regulation is always a double-edged sword, and that is certainly true of the EU’s attempts to create a single market for investment services and activities. Dark pools, high-frequency trading by firms using mathematical algorithms and a plethora of new competing exchanges are all relatively recent phenomena, having grown dramatically since the implementation of MiFID I (Markets in Financial Instruments Directive I), which came into force in November 2007.
MiFID I applied mainly to equities, and whilst it had many positive results, it also had some undesirable and unforeseen consequences. MiFID II is coming into force on 3 January 2017. European institutional investors do need to take an interest, even if they are not directly affected.
MiFID II addresses three key areas. Firstly, it represents the last leg of the European Commission’s post-financial crisis commitment to the G20 to reduce the risk in, and bring transparency to, the world of OTC derivatives. This follows the European Market Infrastructure Regulation (EMIR), designed to increase the stability of the OTC derivative markets in the EU, and the Alternative Investment Fund Managers Directive (AIFMD) regulating hedge funds and private equity firms. Secondly, MiFID II addresses the unforeseen consequences of MiFID I, and thirdly, it provides added investor protection.
MiFID II is set to extend the scope of regulation to pretty much all asset classes and a wider set of financial services firms. MiFID I encouraged trading on exchanges against quoted prices, but small lot sizes encouraged the creation of dark pools as investors sought more effective execution for large trades. The fragmentation of trading has also led to high-frequency trading, using algorithms to arbitrage pricing across different platforms – an activity that author Michael Lewis claimed, in his book Flash Boys, was rigged in the US by traders who front-run orders placed by investors. Whether that is true or not is controversial, but MiFID II introduces restrictions on the use of algorithms, high-frequency trading and dark pools.
Another area where MiFID II is likely to have a major impact is through tighter rules around payments and services that could be considered inducements or would influence the overall governance of the related activities.
This could encompass a huge range of activities, including soft commissions and the bundling of ‘free’ research alongside brokerage services. Forcing fund managers to be open about paying for research, whose costs were in the past hidden in transaction fees charged to the funds they managed – rather than to the fund manager’s P&L – will inevitably mean that much research will simply no longer be paid for. The mega firms could conclude that they have enough in-house resources to not require additional payments for all the research they were getting for free in the past, whilst the boutique firms may just be unable to afford it.
While the changes will affect each type of firm differently – and, indeed, probably each firm differently – there is little doubt that pretty much every firm will require changes, often substantial, making them evaluate and change trading practices, operating models and partnerships, and even reconsider the financial viability of some products and activities.
For European institutional investors, such changes mean there could be a substantial indirect impact on their own interests. As Ian Sutherland, chief executive at Kellian Consulting, tells me, there are three questions that pension funds should be asking of their fund managers over the next year.
First, what do the fund managers see as the likely impact of MIFID II on their services? Second, what are they planning to do in response to the implementation of MIFID II? And third, what do they expect of their institutional clients?
Institutional investors have plenty of time still to ensure these questions are being asked at their next meeting with their fund managers. But, with implementation due at the start of 2017, the clock is already running, and time getting short. While not all the answers are available yet, understanding the known unknowns will be critical.
Joseph Mariathasan is a contributing editor at IPE