During February, the European Commission will release the final text for the Markets in Financial Instruments Directive before it is ratified by the European Commission to become law in 2007. What are the implications for Europe’s trading markets asks TowerGroup's Chris Skinner.
In part one of a two part commentary, we reviewed the Payment Services Directive released in December 2005. Part two concludes with a review of the Markets in Financial Instruments Directive, MiFID, and the impact these two regulations will have on Europe’s financial markets overall.
In the first of these two articles, I concluded with the line "if you have not worked out your strategy you better get there fast in 2006 as the clock is already ticking". That was a statement in relation to the Single Payments Market and Sepa, which will be law by 31 December 2010. Now, if you thought that was scary then take a look at MiFID, the Markets in Financial Instruments Directive.The Markets in Financial Instruments Directive MiFID
MiFID came into being in early 2004 although it was actually dreamt up back in the early 1990’s when the European Commission released the Investment Services Directive (ISD). In that first Directive, the Commission tried to force concentration rules into the European equities markets, which actually meant concentrating all trading activities through the national exchanges such as the Deutsche Börse, the Bourse de Paris and the London Stock Exchange. After a decade, those concentration rules were clearly not working as many broker-dealers were trading off-exchange using their own book of business. This is a generally recognised activity known as ‘internalisation’.
In practice, internalisation means that you hold large blocks of trading instruments internally and buy and sell them in a ‘virtual exchange’ internally. The problem the European Commission had with this generally accepted practice is that it is all hidden within the trading firm and therefore not exposed to the regulator’s touch. The result was the idea of creating ‘best execution’ and ‘transparency’ principles in Europe’s securities markets and the birth of MiFID.
Another little quirk occurred as MiFID was born which was that a certain gentleman from Belgium known as Alexandre Lamfalussy, had just delivered his principles for better regulation of the securities markets. The European Commission had asked Baron Lamfalussy – the respected former president of the European Monetary Institute – to investigate how their regulatory process affected Europe’s financial institutions as a requirement of the Lisbon meeting of 2000 when the Financial Services Action Plan (FSAP) was first created.
Baron Lamfalussy and his Committee of Wise Men, known as the Lamfalussy Committee, came back with a four-level process that said:
Level 1 European Commission State the Principles of the Directive through a new body known as the EU Securities Committee (ESC) whilst another new body, the Committee of European Securities Regulators (CESR), develop the detailed wordings of the Directive.
Level 2 Consultation Period with industry representatives, governments and regulators of the Member States of the EU, before the Directive is endorsed by the European Parliament.
Level 3 The Directive is ratified by the European Parliament and passed into Member States’ governments and regulators to implement national legislation.
Level 4 The Directive is Law.
These four levels were proudly presented by Baron Lamfalussy to the European Commission in February 2001. Once agreed, the new process of regulation awaited its first test and the first securities regulation to hit the Lamfalussy process is … yes, you’ve guessed it … MiFID.
So, the European Commission began Level 1 with the idea of redrafting the ISD of 1993. At that point, MiFID was purely the principles being developed, which were that concentration rules did not work and the Directive aimed to increase transparency and best execution by focusing on internalisation issues. These principles also introduced a new term: ‘systematic internaliser’. A systematic internaliser is any broker-dealer who trades off their own account in an ‘organised, frequent and systematic’ manner.
Everything seemed fine in the rose garden of Europe’s better regulation process.
That was until CESR (the Committee of European Securities Regulators) got their quill pens out and began to draft the detailed wordings for MiFID which were released in April 2004. That date set the milestone as the process moved from principles to consultation, as in from Lamfalussy Level 1 to Level 2. Now it gets interesting.
During the process thus far, most of the discussions had been between regulators, compliance departments of securities firms and some industry leaders. Once the consultation period started, a slow burn began. Upon release of the draft Directive, the European Commission had set the date for MiFID implementation, as in Level 4, to be April 2006 – two years after Level 1’s principles came into force.
Today, the Level 4 implementation of the Directive, when it passes into country laws, has been pushed back twice and should currently pass through by November 2007. Even that date is suspicious, as formal Level 2 proposals should have been issued by the European Commission in January 2006 and yet that has slipped back to February. It would not be that surprising to see the final dates for MiFID slip back even further into 2008. Even then, don’t hold your breath.
This is not because the European Commission is tardy or wayward. In fact, they appear to be surprisingly accommodating and have to be applauded for their consultative approach. That is the spirit of Level 2, which has proven to be even more consultative than expected due to massive amounts of pressure to change. Pressure from sell-side firms in particular, as well as some buy-side firms, industry regulators, treasury departments, even vendors, consultants and others.
This pressure built during 2004 like a slow-burning pressure cooker and exploded during 2005. The explosion was that MiFID was wrong. What was wrong? A lot.
To start with, much of MiFID’s detailed wordings released in April 2004 were ambiguous or did not represent the actuality of how the markets worked.
For example, Article 29 focused upon pre-trade transparency requirements for Multilateral Trading Facilities (MTFs). MTFs are typically electronic networking venues such as an ECN (Electronic Cross Network) or ATS (Alternative Trading System). Article 29 in the original MiFID wordings read as follows:
All MTFs must "...make public current bid and offer prices and the depth of trading interests at these prices…on reasonable commercial terms and on a continuous basis during normal trading hours".
Now this may seem picky, but some folks wondered what ‘normal trading hours’ meant. Nine till five? When the markets opened and closed? When all of Europe’s exchanges were open? Equally, this is fine for MTFs but what about the systematic internalisers? What do they have to make public in terms of their ‘depth of trading interests’?
That is just but one example of a thousand questions raised as broker-dealers, exchanges and vendors picked through the detail of MiFID. Most of the issues were also related to changes to IT Systems. For example, MiFID had words around being able to reconstitute a trade in its entirety for a period of five years. That raised fundamental questions around what does ‘reconstitution’ mean because if it included all data and voice transactions, as in telephone calls, then the implications for data storage and retrieval are horrendous.
None of these questions were raised initially because the interface between MiFID’s wordsmiths and the industry were the compliance folks who are not technologists. It was only when the technologists read MiFID that they realised it could be a nightmare. In particular, a few people in London realised the full extent of the havoc MiFID might create in the technology rooms and have been championing the campaign to change it.
Chris Pickles of BT Radianz has been a particular catalyst. The reason Chris has been so important is that he saw the hazards of MiFID very early on during the consultation period. This resulted in the launch of the MiFID Joint Working Group which has mobilised the key industry associations of FIX Protocol Ltd, Isitc Europe, the Reference Data User Group(RDUG) and SIIA/FISD to work together to analyse MiFID’s true costs.
The MiFID JWG continue to lobby the European Commission and other bodies involved in securities regulations, including the regulators and treasury departments of governments of the Member Sates of the EU. That is one of the reasons why MiFID’s dates have fallen backward, because all of these individuals and institutions are working hard to get MiFID right.What Will MiFID Cost?
Now to the rub. What will MiFID cost?
There are figures ranging from $1 billion to $20 billion touted around. For individual firms, you hear numbers ranging from $5 million to $50 million. The fact is that no-one knows what MiFID will cost. They will not know until the European Parliament ratifies the final wordings in the second quarter of 2006.
The best anyone can do today is to estimate the implications of MiFID based upon the most likely scenario for its final form which is what TowerGroup has tried to do, further to extensive work with the MiFID JWG. As a result, TowerGroup estimate that the average broker-dealer firm, categorised as a systematic internaliser, will need to spend $22 million on new systems and business transformation to comply.
Much of that technology spend will be on massive amounts of data storage and retrieval, networking overhaul to exploit IP-technologies, algorithmic trading and order management and routing applications to improve straight through processing, and so on. This is a considerable investment with the bulk of it going into data warehousing and interoperability. Interoperability will be driven through conformance with standards, with the FIX Protocol being a winner in setting the standards for the pre-trade and trade area. Meantime, most firms will have to undergo extensive business process change to enable best execution compliance, and so a radical shake-up of most firms will be required.
This is not just for the systematic internalisers though, as buy-side to sell-side networking, linkage and operations will all change too. The trade lifecycle will be challenged as costs become transparent. Asset managers will demand they only pay for trade services and sell-side research will be stripped out of the process and sold separately. Connectivity will be overhauled and low-cost connections demanded. IP-networking will replace fixed and leased lines.
One feature most open to change will be market dynamics, in that the sell-side will no longer be able to sustain paying for buy-side connectivity. This will be due to transparent pricing strategies where all sell-side costs of trading will be visible to the buy-side. As connectivity pricing is outside the control of sell-side players and relies on firms like TNS and BT Radianz, the sell-side will let the buy-side determine their own cost of connectivity.
The more you think about it, the more extreme the implications of change in the European securities markets created by MiFID. Regardless of the final wordings, all securities firms involved in trading equities, options, derivatives, bonds and foreign exchange need to get up to speed fast if they are to avoid being railroaded by the Directive in 2007. Yes, you heard correctly, it does include all trading instruments not, as most people misperceive, just equities.
This is why Merrill Lynch and Citigroup recently moved to develop their own exchange platforms. As such, they become electronic trading venues or MTFs and so take advantage of the differing rules for MTFs as compared to systematic internalisers. TowerGroup expect the same to be true for many other ‘systematic internalisers’, with increasing numbers converting to MTFs over the coming months.
Therefore, although TowerGroup can estimate the individual costs of MiFID for the average systematic internaliser as $22 million, there is no way to estimate the total cost of MiFID for European securities firms. First, because the Directive is not ratified; and second, because no-one knows how many systematic internalisers there will be.
At present, there are estimates of anything from 50 to 500 systematic internalisers across Europe’s securities markets. The actual final number will depend upon how many internalisers convert to MTFs and how many regulators determine that their national securities firms are trading as internalisers.
National regulators are able to determine which firms are systematic internalisers by using the definition that it is those firms who trade in an ‘organised, frequent and systematic’ manner off their own book of business. That definition is still very loose and hence some EU states may have three systematic internalisers, whilst others might have 30. It will all depend upon a consistent approach and definition of what a systematic internaliser might be amongst the various regulatory bodies of Europe such as Bafin in Germany and the FSA in the UK. Such consistency of approach has not been implemented previously and so it remains to be seen how MiFID will differ.
Therefore, estimating the total costs of MiFID is pretty much impossible. All we can say is: a lot!Is that it?
That pretty much finishes our rapid review of the New Legal Framework (NLF) for Payments Directive and the Markets in Financial Instruments Directive (MiFID) – two central pillars of the Financial Services Action Plan (FSAP). Bet you thought that was pretty long and complicated. Well, just wait for the rest.
NLF and MiFID are just two of 42 Directives with several more to come. In 2006, you can expect to see the Mortgage Credit White Paper, revised Banking and Insurance Directives relating to Mergers and Acquisitions, a decision on Giovannini’s Clearing and Settlement standards, the creation of a Retail Financial Services Expert Group, an eMoney Directive … the list goes on and on. In fact, there is a virtually never-ending list of committees, conferences, councils, commentaries, conclusions, conversations and more that are debating, discussing, developing, delivering and driving the FSAP.
The FSAP itself is still only half-way through its cycle of development and implementation, but it now has the basic pillars and foundations built on paper. The brickwork and roofing is still to be built by Europe’s banks.
With NLF costing banks upwards of $40 billion (Eurovision 2006: Part One
) and MiFID costing from $1 billion to $50 billion dependent upon the final implementation, Europe is going to see an awful lot of activity for the next five years. Good news for citizens, corporations and vendors. Bad news for banks and brokers, although it could be good news for Europe’s large banks.
Europe’s biggest pan-European operators – ABN Amro, ING, Deutsche Bank, BNP, Societe Generale, Credit Lyonnais and so on – as well as the other banks in Europe with pan-European capabilities – CitiGroup, Bank of America, JPMorgan Chase – should see the Financial Services Action Plan as a great opportunity. An opportunity to create an integrated pan-European banking operation. One which could compete across Europe for the business of the world’s largest organisations. In cash and treasury management operations therefore, the FSAP has to be great news for both corporates and pan-European banks.
For the corporate, it means they can potentially run their complete European business through a single account, rather than having an account in every nation. That should mean considerable cost savings. Even if they do not go to a single European account, they will get considerable cost savings anyway as the FSAP wipes out banks’ cross-border margins.
For the pan-European bank, it means they can finally consolidate and create a competitive European financial zone. One that competes on equal status with any geography in the world. One where the biggest banks can only get bigger and where they can truly leverage the economises of scale that a harmonized and integrated European market offers.
Meantime, for the central banks and infrastructures across Europe that support these activities there will be blood on the floor when the inevitable fall-out from these changes hit.
In the five years left to implement the FSAP, and the five years that will follow as banks, clearing houses, brokers, asset managers, insurers, intermediaries and the rest fight for position, there will be a great battle. A battle for Economic & Monetary Union supremacy and survival. The equivalent in the financial markets of Tolkien’s epic battles in the Lord of the Rings. Only in this battle, there is room for more than one ring and the question is which firms will have a hand left in the markets to wear them once the battle is concluded.
It should be fun to watch.Chris Skinner is a director of TowerGroup and founder of Balatro.
Web links: www.towergroup.com
Author's email: Chris Skinner
Chris has written six reports in this area for TowerGroup and is running regular one-day workshops for banks and vendors on the implications of Europe’s Financial Services Action Plan, MiFID and Sepa.