Europe and America are introducing a wave of regulatory changes that are creating as much emotion as Basel II, with MiFID and RegNMS leading the way. Comment by Chris Skinner
In Europe, the Markets in Financial Instruments Directive – otherwise known as MiFID – will be implemented by April 2007 whilst, in the USA, Regulation NMS (National Market System) is targeted for full-scale operation by July next year. The intention for both regulations is to ensure best price execution, but the concern for securities players is how these legislative changes will impact their margins, pricing and competitiveness.
For example, under Regulation NMS, a market centre must "establish, maintain, and enforce policies and procedures reasonably designed to prevent ‘trade-throughs’ — the execution of an order in its market at a price that is inferior to a price displayed in another market." The Regulation goes on to argue that a national market system which is run in an efficient manner should guarantee the 'best execution' for each and every transaction within an order.
MiFID has a raft of statements with a similar intent. A specific example is detailed in Article 21 which deals with 'best execution' at the most favourable terms to the client. Within Article 21 are statements such as "the order execution policy shall include those venues that enable the investment firm to obtain on a consistent basis, the best possible results for the execution of client orders."
But MiFID goes a step further than Reg NMS with Article 27, which states that dealers "shall make public their quotes on a regular and continuous basis during normal trading hours - the quote shall be made public in a manner which is easily accessible to other market participants on a reasonable commercial basis."
This is specifically targeted to stop off-exchange trading and the unregulated dealings of brokers trading off their own book of business, defined as 'systematic internalisers'.
That means European broker-dealers, who previously could compete from a private book of business at competitive rates, must now publish their prices publicly and be able to prove that their price is better than their competitors’ best price at the time of the trade.
However, as managing director and international general counsel of Morgan Stanley, Keith Clark, stated in a recent interview with the International Financial Law Review: "Article 27 of MiFID, which deals with pre-trade transparency, is a political compromise driven by all the worst elements of European lawmaking. It is quite difficult to reconcile the requirements of France and Italy, which have historically had difficulties with off-exchange trading, with the internalisation approach that has worked well in the US and which we would have preferred to have been the model in Europe."
What he means by this is that CESR – the Committee of European Securities Regulators who are responsible for writing the MiFID regulations – has created a directive based upon every possibility of variance to the Nth degree of detail. CESR have basically tried to take into account all aspects of all markets in Europe, and documented all possible nuances of how these markets operate, to ensure that every nuance of every market now offers best price execution. It might have been better just to extend the principles of the intentions of what MiFID is meant to achieve rather than battening down every detail. That is why the Directive has become such a can of worms and has had to be delayed by a year from its original implementation due in April 2006.
Between Regulation NMS and MiFID, the industry feels an immense sense of loss of competitiveness because margins are squeezed due to market transparency, whilst costs are increased due to increased regulatory overheads.
And these regulations do imply significant cost overheads. For example, the implication of MiFID Articles 21 and 27 – publicly issuing prices to ensure best execution – is that a European dealer now has to track and store every price movement for each and every financial instrument from every market player at every micro-second of market trading. They then have to store that information for as long as the regulators require, in proving that they executed at the best price for all equities, bonds and derivatives they trade across the spread of their portfolio. Considering the volume and value of trading in the marketplace, that implies one heck of a lot of data storage.
The growing cost burden is also a major cause for concern across the Atlantic. At a recent SEC open meeting regarding Regulation NMS, dissenting Commissioner Cynthia Glassman made the following point: "The cost savings to investors from the rule is estimated at a mere $321 million … given that dollar value of trading totalled $18.7 trillion in 2003, $321 million is only a rounding error … the cost-benefit analysis estimates start-up costs at $143.8 million, with average annual ongoing costs of approximately $22 million."
Whatever the pros and cons of regulatory changes, the implications for the securities industry is heightened transparency, reduced margins, increased onus upon data integrity and storage, and an honesty that has had to be forced into the marketplace due to the lack of trust of off-exchange trading in the past. And maybe that is where we should learn our lessons in that it was the dealings of the few that has created the problems for the many.Chris Skinner is a director of TowerGroup and founder of ShapingTomorrow.com.
Web links: www.towergroup.com
Author's email: Chris Skinner