What’s Mifid II and why do we need it?
It’s a game-changer. And like a lot of modern financial regulation, you can thank the G20 Pittsburgh meeting in 2009 for it.
In 2014, the Markets in Financial Instruments Directive (Mifid) II was pitched as an update to the 2004 version of Mifid, but it quickly became clear that it would be so much more than that.
As is known, there was a lot of criticism of the way financial markets were regulated in the period following the crisis. Action had to be taken to protect everyone involved, from the markets themselves and the systemically important institutions that operate in them, right down to the end consumer.
So Mifid II touches practically every corner of the finance world, whether it’s in the form of new product governance rules that protect retail investors to highly technical distinctions between different types of trading venues and instruments.
It’s a mammoth task. A task so huge in fact, that much to their dismay, European regulators have already been forced to delay implementation by a year, to January 3 2018. Without wanting to dash the hopes of too many in the market, it’s not going to be delayed again, so now Mifid mania has set in. Firms have appointed entire teams to deal with the new directive – City research provider Peel Hunt has put 10% of its entire workforce on its Mifid II taskforce.
Implementing it has been difficult because of the very makeup of the EU. Mifid II is a directive, not a regulation and so member state authorities have considerable freedom when transposing it into national law .
It has got an accompanying regulation, Mifir, which admittedly hasn’t made as many headlines. That could be because the acronym doesn’t have the same satisfying ring to it – but it also could be because the directive is where most of the meat can be found.
Why is transparency so important?
The failures of the financial crisis made everyone realise just how opaque markets were. For certain products, no one really knew who owned what, nor who owed what and to whom, making resolution situations significantly more difficult to muddle through.
There were also, as is well known, instances of misconduct and poor treatment of client money. Certain players were caught taking unnecessary and excessively perilous risks with customer deposits, or selling highly complex, exotic products to retail investors, without making clear the dangers involved.
The emotional, human side of the crisis – penny-pinchers losing their lifelong savings when their retail bank went under, and grannies being sold credit default swaps with the promise of no risk and huge returns – and the subsequent public disdain towards banks has made it clearer than ever that this cannot happen again.
How does Mifid II help?
The central premise of Mifid II is to shine a light on some of the shadier corners of the finance world by improving the transparency around markets and investment decisions. It does that in a few different ways.
The directive’s reporting requirements, which govern pre and post-trade transparency, are vast and far-reaching. Pre-trade rules require venues to publish information on bid and offer prices, while for post-trade rules, the clue is in the name: venues must report after the trade has been executed, as close to real time as possible.
Firms will have to provide pre and post-trade disclosure of the detail of orders submitted to a regulated market, including price, size, and a whole range of personal details for the traders – or the algorithms – conducting the deal.
Then there’s transaction reporting, which involves providing the national competent authority with reference and post-trade data. Firms must submit further information on their positions in commodity derivatives to ensure they are not exceeding position limits. Market participants say this rule will instantly make non-EU commodity markets more attractive.
For some instruments, firms will only have to report subject to a liquidity test – for instance, does the product trade more than 15 times a day?
It’s not yet clear what regulators plan to do with all of this data. “When we’re spending this much time on it, it’s important for the industry to know what is going to happen with all this information,” says a Dublin-based fund manager. “It would help if we knew exactly what policy objective this is all working towards.”
It’s thought that for the time being at least, the requirement alone will deter wrongdoing, even if the regulator is not reviewing the data – a bit like a speed camera that’s been switched off.
Firms will also have to provide data demonstrating their compliance with new best execution obligations.
What’s best execution?
Best execution, as a concept, has always existed and should always have been at the forefront of traders and managers’ minds: it’s the simple duty of providing the best possible service for the end client.
But what’s new under Mifid II is the sheer amount of information required to demonstrate their commitment to best execution. Mifid’s first iteration asked firms to take all ‘reasonable’ steps in the interest of their client. Mifid II asks for all ‘sufficient’ steps.
Firms must consider: price, costs, speed, likelihood of execution and settlement, size, nature, or ‘any other relevant consideration’ – so quite a bit. And they’re not only gathering data on their own deals, but also on others in the market for comparison. They must also keep records of all interactions with the client that resulted in that transaction.
And when there’s more than one venue competing to execute the order, a firm must demonstrate why it picked one venue over another.
“Best execution has always been an important activity for banks, but the challenge now is to do it at greater speed, and to warehouse the enormous amounts of data now involved,” says Peter Farley, capital markets strategist at Finastra.
That’s introducing major IT challenges, which of course presents opportunities for fintech firms.
Don’t firms already have to report?
Some of this does already exist. Under Mifid, pre-trade transparency requirements applied to equities admitted to trading on a regulated market.
Mifid II and Mifir expand the scope considerably to include fixed income, derivatives and commodities, as well as any instrument that is traded on a trading venue, catching anything done over-the-counter. It also captures derivatives traded outside of the EU, if the underlying transaction was traded within.
"It would help if we knew exactly what policy objective this is all working towards"
There’s also two new types of trading venues: multilateral trading facilities (MTF) and organised trading facilities (OTF).
“We expect a lot more interaction with supervisors around how we choose trading venues and how we can demonstrate best execution,” says the fund manager. “There’s so much more to do, including installing new systems, for everyone to feel comfortable and compliant.”
What are people so worried about?
The lack of practical guidance has got much of the market bogged down in definitions and technicalities. Inconsistent interpretation of the rules could result in firms under or over-reporting, producing a potentially skewed picture of the market.
But the market has bigger fish to fry than that. Mifid II has a long arm of oversight, so non-EU clients that trade on EU trading venues will be caught by the rules. But here’s the catch: as they won’t technically be Mifid firms, the responsibility falls to the venue they trade on. Jason Waight, head of regulatory affairs at e-trading platform MarketAxess, says that around 30% of its MTF flow comes from non-EU clients. “That’s a lot of people to transaction report on behalf of,” he says.
Another source at a trading venue says he is hoping as many asset managers as possible register as Mifid firms, “otherwise we’re lumbered with all their reporting, including infinite passport numbers”.
Plus, the level of granularity is unprecedented. Data fields have jumped from a modest 25 under Mifid to 65 under Mifid II.
Natural persons must be identified including dates of birth and home postcodes, as well as the passport numbers of anyone making investment decisions.
That’s operationally challenging at the best of times, but it’s a real issue when it comes to data protection laws in certain jurisdictions. And it’s particularly iffy in jurisdictions where personal privacy is more ingrained in cultural norms and business.
Plus, the majority of these clients are not acting on their own books anyway, so would need to get the passport numbers of their underlying clients. That’s difficult for obvious reasons.
If the non-EU client refuses to provide the data – which looks likely – it comes back to the trading venue. For their part, venues have created ring-fenced data stores for clients to deposit this information – but as expected, few have been forthcoming.
A mismatch between Mifid II’s reporting requirements and the local numbering and reporting systems of non-EU jurisdictions is also causing problems.
Can’t firms get around it?
Non-EU firms could, but that’s an even worse outcome for those left behind. And it’s a very real concern – this week a group of bond trading firms including the London Stock Exchange, Nex, MarketAxess and Tradeweb pleaded with EU regulators to review some of the further-reaching transparency requirements.
They foresee mass migration to non-EU capital markets after January 3, striking a blow to the EU’s ongoing competitiveness. To prevent this, the firms are urging the regulator to limit the personal data requirement to market participant-level, rather than that market participant’s underlying client. An amendment at this late stage is unlikely, but not impossible.
Either way, there are opportunities for non-EU markets and trading venues. New York, Hong Kong and Singapore are all expected to reap the benefits of Mifid II’s long arm on transparency.
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For Mifid II’s impact on research click here and for more primers, click here.