Mapping out the direction of this year’s Mifid review

IT’S simple really. The outcome of Mifid II will include: more stringent regulation of best execution obligations, a move towards the introduction of a consolidated tape, an increased push for transparency, a higher number of trades at a higher speed, lower fees, tighter spreads, the introduction of a single passport to give improved access to a single, pan-European market, and further liquidity fragmentation.

The original Mifid changes broke the LSE monopoly to some degree in a push for best execution (see the Fidessa chart below) but this still has some way to go.

It is difficult to predict the effects two or three years down the line, but, as a result of the changes to rules, the structure of the markets in financial instruments will be reformatted.

According to Derek McGibney, management consultant for the IMS group, “the aim of the review is to give participants greater transparency. However, this increase in transparency may in certain markets have the side effect of reducing incentives through reduced risk and with it reduced exposure to returns.” According to McGibney, this increased transparency is a double edged sword: “While this increased transparency is a good thing for participants who are less experienced investors, for the professional investor, this leaves less incentive as there is less reward for taking on risk. These investors will naturally be incentivised to migrate to areas where there is less transparency, ergo greater risk and potential for returns.”

Should the measures that are predicted from the Mifid review be applied uniformly and in Europe in isolation, then this kind of arbitrage will be a real concern. According to McGibney: “While we welcome increased transparency where it is expected, the risk is that – if this type of legislation is not adopted similarly across the globe – there may be scope for arbitrage across markets, which is a valid concern.”

Under the original directive, certain organisations were classed as eligible counterparties. Those within this category were allowed to waive conduct of business obligations when executing trades with investment firms. This meant that dealers could execute an order without first assessing whether the product was appropriate – and in doing so allow high speed traders to escape being bogged down by regulatory red tape.

In the review, it is expected that there will be a limiting of the eligible counterparty regime. In a consultation document in December, it was recommended that the new directive would exclude products such as asset backed securities and non-standard over-the-counter (OTC) derivatives from this waiver. Furthermore, given the losses accrued by municipalities and public authorities under the previous regime, it is expected that these non-financial institutions will be booted out of the eligible counterparty tree house completely.

With this slew of regulations, there will come the inevitable expense as institutions rush to comply with the directives. Though these will initially be shouldered by institutions, it is likely that they will later be pushed down the chain. These costs will eventually be spread across the market via transaction costs. And soaked up by consumers.

As with all heavy handed European regulation, one hopes that they will not throw out the baby with the bathwater.

Original Mifid Classifications

Retail clients – afforded the most regulatory protection
Professional clients – considered to be more experienced, knowledgeable and sophisticated, and are able to assess their own risk. Professional clients are afforded fewer regulatory protections
Eligible counterparties – investment firms, credit institutions, insurance companies and other regulated financial institutions given light touch regulation regime is provided for when investment firms enter into transactions with eligible counterparties.