The MIF II directive came into force on January 3rd, 2018. Now being eleven months on from its implementation, and the dust having somewhat begun to settle, can we start assessing the consequences on the European financial markets and their players? Of course, the full effects of the directive are not yet known, but we can already provide some insight into the impact of the directive on capital market players, as well as the markets themselves.
Impact on Capital Market Players
Commission (credit: Xavier Häpe)
Changes to Existing Trade Venues
Broker Crossing Networks (BCN), used by traders to execute client orders against each other or on own account, and comparable to OTC trading with transparency issues, have been eliminated under the new regulations.
As for dark pools that allow large orders to be passed with no pre-trade transparency, their activity is now limited by the double volume cap mechanism, which currently affects more than 600 financial instruments whose exemptions permitting dark pool trading have now been suspended.
However, liquidity of equity markets has not necessarily been transferred to regulated markets. It has instead shifted towards systematic internalisers who currently capture a quarter of all trading volumes. They are authorized to execute client orders on own account only and must publish their quoted prices when orders are below standard market size.
At the same time, the directive has introduced a new category venue, the OTF (Organised Trading Facility) for trading in all instruments except equities, and in particular for derivative contracts. These platforms act as intermediaries between buyers and sellers and provide a minimum of pre- and post-trade transparency. There are currently 72 OTFs authorised and listed in the ESMA register.
Lastly, the directive has also created the SME growth market to facilitate access to capital for small and medium-sized companies. However, to date, only two have registered with the ESMA, although there are many more platforms in Europe (e.g. Euronext Growth) that fit this category of issuing companies.
New Players for New Requirements
Requirements in terms of trade reporting have been considerably tightened by MIFID II. Investment firms who need to meet their transaction reporting obligations can use the services of ESMA authorized intermediaries, the ARM (Approved Reporting Mechanism). At this time, 22 entities have been authorized by ESMA to provide reporting services. In fact, many of them are also regulated markets or multilateral trading facilities.
Brokers-dealers are now required to unbundle their transaction fees into research and execution charges, which in turn draws more attention to investment research costs (micro and macro-economic data analyses) on the part of investor clients. This is opening up opportunities for specialists in the field such as IRPs (Independent Research Providers) or platforms that aggregate research from various sources known as ORMs (Online Research Marketplaces).
Broadly speaking, the multiple new obligations that both buy-side and sell-side traders are required to meet creates a need for new specialist Fintech firms. For example, the obligation to record each client exchange generates the need for recording systems that automatically transcribe speech into text.
Changes and Developments in Economic Models
We have already mentioned unbundling of investment research costs from transaction costs that has led traders to review their business strategies.
However, another major aspect of the directive is the obligation for FIAs (Financial Investment Advisers) to either opt for independent advisers and give up their advisory fees and commissions or clearly operate as an investment adviser providing unrestricted advice in order to claim their fees. As for discretionary investment management, accepting or retaining commissions is purely and simply forbidden. Consequently, compensation for these activities is now only derived from client fees. No doubt these new obligations have had an impact on the business models of private banking and asset management, but it is still too early to evaluate.
Impacts on the Markets
MIF II has a strong impact on negotiated transactions especially with new constraints concerning tick sizes, which are clearly aimed at discouraging algorithmic trading. Recent studies on equity market quality have shown that there is a notable improvement in market depth (increase in quantities available at the best limits) and less messages leading to noise reduction in the order book. As for spreads, they have decreased for small transactions, but have on the contrary increased slightly for more liquid securities.
Although dark pool trading volumes have dropped significantly, the size of orders on these platforms has practically doubled. This is due to the fact that dark pool limitations do not apply to large transactions. Investors wanting to negotiate "discreetly", namely to avoid impacting the markets too rapidly with a large order, still resort to using dark pools.
In fact, for many corporate investors, the lack or limited transparency of the market is a means of acting in the client’s best interest, by guaranteeing optimum buy/sell prices, as long as it does not interfere with transaction prices. The regulator is well aware of this practice (albeit not enough in the view of some professionals) and that is why the complexity of certain rules is really a matter of “fine tuning”.
New Market Data
The Regulatory Technical Standards (RTS), articles 27 and 28, are applicable to both platforms and investment firms who are required to publish data regarding execution quality of client orders on a regular basis. This information, in particular data provided by platforms, will undoubtedly be a precious source for researchers and market players in the future. Data format, specified by the ESMA, is standardised, and has to be accessible to all, in a legible digital format. At first glance this all looks very interesting, but a lot of work will be needed to process the huge volumes of data at financial institutions. However, the prospect of being able to interpret market tendencies does seem interesting.
Furthermore, the directive has triggered the production of an enormous amount of new reference data and market data related to financial instruments. Some of the reference data concerns e.g. instrument classification, target markets, identification of leverage products or complex products and liquidity indicators. As for Market data, examples include the need to determine standard market size of instruments, their liquidity and pre- and post-trade transparency requirements. All of these data must be properly collected, monitored, classified and distributed and then most importantly used appropriately.
All of these aspects and certainly others that we may have missed, will keep analysts and consultants busy for years to come. We will probably be able to start identifying the long-term trends after the end of the 2018 financial year. Among these, we will undoubtedly find heightened competition and growing pressure over cost regulation, making the trading business more and more inaccessible to players that do not reach the minimum critical size.