The entry of the Markets in Financial Instruments Directive (MiFID II) into force on 3 January 2018 was a momentous occasion in European, and possibly, global financial markets.
One of the more controversial elements of MiFID II is the unbundling of research payments by investment banks and brokers into a separate, disclosed fee for research; that fee is to be paid either by the end client (out of a pre-agreed research payment account) or out-of-pocket by the investment manager. After some early uncertainty, it seems that the majority of managers will simply pay out-of-pocket for research, which will put further pressure on profit margins. How much this will actually cost managers is still an evolving issue. To inform the debate, CFA Institute asked its members about their expectations for research costs and published the results in MiFID II: A New Paradigm for Investment Research.
As of mid-January 2018, the introduction of most MiFID II provisions, such as the research unbundling regime, appears to have gone smoothly. This is a significant achievement considering the European Commission’s (EC) own estimate that only 16 of 28 EU member states have transposed the MiFID II rules into national law. However, the provisions relating to market structure have not had such an easy ride.
Dark pool double-volume cap
A key aspect of the MiFID II drive to improve market transparency is its provisions limiting dark pool trading. We have previously written about it but to recap: the double-volume cap limits dark trading when a stock’s dark-trading volume on a single exchange exceeds 4 per cent of total stock volume across all trading venues, or when dark trading in a given stock across all trading venues exceeds 8 per cent of total stock volume across all trading venues. When those limits are reached, those stocks can only trade on pre-trade transparent venues, such as traditional exchanges, where details of bids and offers are published prior to transactions taking place.
It has been known that the double-volume cap would be difficult to implement since at least November 2015. At that time, Markus Ferber, a Member of the European Parliament’s Economic and Monetary Affairs Committee, and rapporteur on the MiFID II dossier, commented during a public appearance that the double-volume cap was an unsatisfactory compromise.
Specifically, Ferber noted that a lack of sufficiently accurate data across European markets may mean that the double-volume cap will be unworkable or have no impact, as it will be difficult to demonstrate that a particular trading venue in a particular stock has breached either of the percentage caps during any period. These concerns led to a clause in MiFID II requiring a review of the double-volume cap by 3 March 2019, one of only a few such clauses in MiFID II.
The concerns over the practicability of enforcing the double-volume cap have been shown to be prescient. Despite efforts by regulators, ESMA, and trading venues, six days after news broke that the introduction of the double-volume cap is being delayed a further three months due to a lack of complete data from a large proportion of trading venues. ESMA reported that while 75 per cent of trading venues have reported some data, much of the data are incomplete. Only 650 instruments of around 30,000 due to be reported (i.e. 2 per cent) have had complete data filed with ESMA. ESMA’s ambition is to finalise this process by March 2018 and publish the list of instruments captured by the double-volume cap for the period beginning January 2018, although market participants are not clear on how the cap would be implemented retrospectively.
If and when these bans on dark trading start to take effect, trading is expected to migrate to public exchanges or registered systematic internalisers (SIs)–a group of banks and market makers that operate under a less-extensive, off-exchange trading regime.
Is the SI Rule loophole fixed?
A Systematic Internaliser (SI) is a firm that uses its own account to deal in an organised, frequent, and systematic basis by executing client orders outside of a regulated market (i.e. an exchange) or multilateral trading facility. Much has been written about the SI regime and the possible loophole it provides for market participants to work around the spirit of MiFID II and keep the most profitable trading in the dark. Although broker-crossing networks are not allowed under MiFID II, the SI regime allows for bilateral trading between a principal (e.g., a market maker or broker) and a client.
CFA Institute previously acknowledged the positive effects that so-called dark trading can have on market quality (with caveats) and the SI regime broadly falls in that category, enabling market participants dealing on their own account to execute over-the-counter transactions with clients efficiently. However, it is not difficult to imagine an SI having an automated quoting system in which quote feeds from various sources (including other SIs) go into an execution engine that automatically selects the most desirable execution outcome for the client order. The concern is that this will serve as a loophole for market participants to register as an SI and create SI networks. By connecting to one another to create de facto multilateral trading venues, they could essentially re-create broker-crossing networks, a result not intended under MiFID II.
As the Financial Times (21 February 2017) notes, the attraction for high-frequency trading (HFT) market makers to operate under the SI regime is the ability to execute transactions with selected clients in private. The allowed reporting delay under the MiFID II regime (within a minute of a transaction) would give the HFT algorithms more than enough time to hedge the position on an exchange before the original trade is made public.
In the CFA Institute comment letter on the EC’s proposed amendments to the relevant Delegated Regulation, we noted our support for a level playing field approach to the SI regime and supported the amendment to not consider a firm to be dealing on its own account (i.e. acting as an SI) when that firm participates in activities that result in de facto riskless back-to-back transactions outside a trading venue.
CFA Institute is also responding to another SI-related consultation, this time from ESMA. In this consultation, the issue at stake is that the SI pre-trade transparency requirements are ambiguous as to the tick size regime that can be used when quoting prices. The additional flexibility provided to SIs in this regard, particularly the possibility to quote in smaller price increments than those allowed on trading venues, could allow SIs to provide only nominal price improvement to attract execution away from trading venues.
This nominal price improvement phenomenon has been observed in the United States, and CFA Institute has previously commented about the issues involved. We believe that SIs should be allowed to offer price improvement in the form of more favourable execution prices compared with prevailing price quotations, as long as it is being done to provide investors with meaningfully better outcomes than otherwise available on exchanges. Price improvement provides benefits to investors but also creates opportunity costs for displayed liquidity providers on exchanges.
Ensuring that the SI tick size regime for price quotations is the same as for other trading venues should help to provide a level-playing field for market participants by eliminating the arbitrary regulatory difference in tick size regimes.
Another way MiFID II attempts to create a level playing field is by opening up the clearing of futures contracts to competition. Specifically, the ‘open access’ changes would allow clearing houses to compete for the clearing of contracts on any futures exchange. However, on the MiFID II launch day, regulators in the UK and Germany (later joined by Sweden) gave a 30-month reprieve to their domestic exchanges—London Metal Exchange, ICE Futures Europe, and Eurex, respectively—from complying with these changes.
The proximate cause for these delays was given as the uncertainty surrounding the status of the UK’s capital market post-Brexit, although others say it is a case of regulators caving to vested interests. Interestingly, this move by the UK regulator stymies the London Stock Exchange’s ambitions in this space, with its CurveGlobal derivatives exchange maintaining its commitment to the open access rules despite the waivers granted to its UK competitors.
MiFID II was conceived in the post-crisis and pre-Brexit era of the early 2010s so it is not surprising that aspects of the regulation are proving difficult to implement. As Ferber commented: “If the most developed and most liquid of all current EU markets is taken out of the equation, certain adjustments have to be made.”
With the 3-month delay on the double-volume cap, the 30-month delay on futures-clearing provisions, and the yet-to-be-determined impact of research unbundling and the SI regime, it is probably better to not think of 3 January 2018 as some kind of finishing line, but rather as the end of the beginning. Market participants and other stakeholders have been half-jokingly, half-worryingly, referring to MiFID III for a few months; perhaps before that we will need a MiFID 2.1.