Lingering Questions Remain over Mifid II

Like the sequel to a blockbuster film, there was a lot of hype before the launch of the revised Markets in Financial Instruments Directive (Mifid II) on January 3. The European regulation had been many years in the making. Its origins stemmed from the 2008 financial crisis to meet the demand for greater transparency and accountability in the markets.

But while the dust has still not settled in respect to the changes brought about by Mifid II, there is already talk about further changes to the regulation through a so-called Mifid 2.5, or, whisper it quietly, even Mifid III.

“I think it is not too outrageous to state that obviously the next revised version of Mifid will probably not be as big as Mifid II,” says Christian Voigt, senior regulatory advisor at Fidessa. “Because the number of changes that were in Mifid II was unusually high. There will be fewer, but there will be some changes coming.”

This feature will examine some key regulations introduced with Mifid II, and review their performance with the help of market experts. 

The Double-Volume Cap

The double-volume cap (DVC) was one of the more controversial measures introduced in Mifid II. Its purpose was to increase trading in the lit markets by placing caps of four and eight percent for individual stocks on trading in dark pools enforced with the help of six-month trading bans on dark venues.

It was in the middle of March when the first batch of stocks were suspended under the double-volume cap regime. After they were re-introduced in September, dark trading in small trade sizes increased significantly. 

According to Fidessa’s Voigt, the DVC is a “failure” because it hasn’t really changed behavior. He says that due to the way the patterns are right now, all of those stocks that have seen increased trading in the dark are likely to be banned again. “Therefore, we will end up having a see-saw pattern, if you will, where stocks tend to go in and out of the double volume cap. In the end it doesn’t really achieve anything other than you are restricted sometimes, and sometimes you are not,” he says. 

Voigt doesn’t mince any words in his critique of the caps. “Living under them for nearly a year, for at least 11 months, I would definitely say that all the concerns about the DVC that were raised before are largely true. It is very cumbersome, it achieves very little, and just makes it very hard to explain to outsiders what is going on,” he says. 

The DVC was largely seen as a last-minute compromise to ease the passage of Mifid II, but certain questions still remain about its construction. Even regulators cannot answer questions around how, for instance, the thresholds for individual and overall dark trading in a particular name were formulated. Likewise, as Voigt says, there are still extant concerns about the objectives of the DVC, which many argue restrict choice at the expense of little transparency benefits.

“What I mean by that is, it is like the rule has this outset assumption that trading in the dark using small sizes is a bad thing. And that is why it says we are going to ban it if it takes too much. But in reality, it is not necessarily a bad thing because there are apparently a lot of investors who voluntarily choose to trade there. And why do they voluntarily choose to trade there? Because in their view it is the most cost-effective way,” he says.

Systematic Internalizers

Systematic internalizers (SIs) first emerged with the original Mifid in 2007. However, they never really took off because of the option of being able to trade in the dark or via broker crossing networks (BCNs). That all changed with the advent of Mifid II, which banned BCNs and energized support for SIs. In the build-up to Mifid II’s go-live, dozens of new SIs were being registered every month.

“Unfortunately, there is a misconception around trading in the dark that all dark trading is bad by certain individuals, mainly exchanges, and they would like to see liquidity to get back into primary lit markets,” says Rebecca Healey, head of EMEA market structure at Liquidnet. “But the reality is that it really depends on the type of order you are trading, and what your trading objective is, as to whether you should trade on the lit, or it is more advantageous for the end investor to trade in the dark. So what I mean by that is if you are trading on the lit market, and you are looking to trade three weeks’ worth of volumes, as soon as you give an indication you may move the price. And that can be quite significant, particularly when you are looking at small- or mid-cap names.”

One of the problems has been confusion in the market as to what should be reported as SI activity. Healey says there is a wide disparity across the industry about what should be included in SI liquidity, and what should not.

“[There is a] FIX working group that [deals with] the Market Model Typology (MMT), which essentially is the different tags that you can add to individual trades to explain what that trade is,” she says. “That has been put together by the industry and we have actually passed it back to the European Securities and Markets Authority (Esma), so they can give us some guidance about what they would like included within the SI calculations, and then we as an industry can implement that across the board to give them the visibility they are looking for.” 

Georg Gross, head of regulatory services at Deutsche Börse, says there is still a way to go until the introduction of the full SI regime. “In effect, Esma has postponed the implementation of the SI regime for over-the-counter derivatives, which will follow in March next year. Although the European Economic Area trade volume data, which allows us to determine whether one of our clients is a systematic internalizer in an instrument or in an instrument class, will be published by then, the data quality still needs to be improved.”  

Reporting

With transaction and trade reporting requirements, an important concern has been the quality of the reporting in the data. “This has been one of the Financial Conduct Authority’s (FCA’s) expressed concerns,” says Bobby Johal, director at ACA Compliance. “They highlighted it most recently in their asset management conference in June or July of this year. Transaction reporting is certainly the key area of focus for them. This is a shiny new toy for the regulator as well. For the six months to July, their systems ingested 3.5 billion transaction reports for the market, which is a significant uptick from the year before, for example. They are very keen to use all this data. So that was a degree of a forewarning to the market.”

He says it is important that the firms report the data properly, as well as ensure the reporting of the right transactions. However, new platforms put into place, such as Approved Publication Arrangements and Approved Reporting Mechanisms (ARMs) ran into problems from the very first day. Waters reported in January that these entities were either malfunctioning and not accepting reports—a problem that went on, in some instances, for months—or had to be shut down entirely, as happened with ARMs in Greece and the UK.

Part of the problem with reporting has also been due to the interpretation of the rules, which can differ significantly from regulator to regulator, depending on which of the EU’s 28 member states a market participant is reporting to. Even for established, sophisticated firms, like Deutsche Börse, this can prove challenging.

“We are not only reporting to [German regulator] BaFin, but also to the FCA, and the French regulator,” says Deutsche Börse’s Gross. “We have 26 different regulators we are reporting into. So I think here the challenge is that although they are all applying the same Esma-defined rules, what we have seen over the last nine or 10 months is that implementing all these rules the same way is sometimes a challenge. All the participants in the market have to recalibrate a bit because of different interpretations of the rules, and therefore we had to align with many regulators and Esma to get a common understanding of what the correct interpretation is. That is a challenge on the transaction reporting side.”

It’s not all bad news, however. Tom Wieczorek, managing director for product management at UnaVista, the London Stock Exchange’s regulatory reporting platform, says that despite issues, Mifid II’s reporting requirements have had an effect on market transparency. “We have seen an impact [from Mifid II],” he says. “The biggest is that more and more firms are trading on exchanges or on trading venues because the regulatory burden of doing things over the counter is increasing. We have also seen more firms electing to be SIs, so operating multilateral trading facilities. In this regard, everything has definitely become more transparent under Mifid, because capital markets are moving onto regulated venues.”  

Because most of their clients are international, Wieczorek says that even though the standards for sending transactions to the individual regulators were all fine, the connectivity, IT infrastructure,
and workflow of each varied a lot. “We are connected to around 20 at this point but it did take some time. Each one of these connections requires us to work closely with the regulator to understand how they get the data, how we connect to them, how they acknowledge receipt of that data and so on,” he says. 

Research Unbundling

One of the cornerstones of controversy under Mifid II was the unbundling of research costs from execution commissions, a transformational shift in how the two have traditionally operated. According to ACA Compliance’s Johal, one of the things that drove the change in the research rules was a desire to break up the oligopoly of a small number of very powerful research providers. The goal was to try and diversify the market and get smaller players out there to provide more choice and promote competition. Yet that may not have been achieved.

“That is not necessarily how I understand firms are seeing it,” he says. “If anything, they are actually using fewer research providers, not more. There is not a great diversity of research providers. But, then again, we are only 11 months into it. There is still time for more players to emerge. It is still very early. But as far as I understand, that objective definitely hasn’t been achieved, and we are not seeing more providers. We are seeing, if anything, a flight to safety,” says Johal.    

The unbundling rules also raise questions with international implications. “The research point is an obvious example where clients in the US are having to pay for things their clients in the UK may not necessarily have to. There is a question more broadly for you as global firm to consider: Is this fair? Is this fair to all your clients?  We are hearing anecdotally that there is a commercial investor-driven desire for some of these initiatives that Mifid II has brought into play, research being the obvious one that we keep coming back to,” he says. 

Duncan Higgins, head of electronic sales at agency broker ITG, has noticed a change. “We look at trading from our analytics clients in Europe, and the average commission rate that they pay on their trades has gone down 30 percent,” he says. “That was the first quarter of 2017 to the first quarter of 2018. We see a reduction of 30 percent on the average commission rate on a trade. There is evidence right there of the implementation of the requirements of Mifid from an unbundling perspective.” 

Best Execution 

Recently, regulatory technology provider Cappitech conducted a survey of over a 100 European buy- and sell-side compliance decision-makers. The survey looked at the impact of Mifid II on the financial services sector, including plans to tackle regulations like regulatory technical standards (RTS) 27 and RTS 28, which cover best-execution requirements. 

The survey found 65 percent of respondents were not monitoring trades systematically according to best-execution criteria, while 60 percent had no plans to use their best-execution reports internally. “Some of the firms did say they perform best-execution analysis, but they do not do it in a systematic fashion,” says Ronen Kertis, CEO at Cappitech. “So they would, for instance, take a few trades anecdotally, check those trades and compare them to the market price at the time using Bloomberg or Reuters terminals, but they don’t have a systematic system in place to check for best execution.” 

The industry spent years preparing for Mifid II, but clearly some are still not quite there. There are a number of reasons for this when it comes to best execution. According to Kertis, the requirements are not a simple undertaking if someone wants to build the technology themselves. “The other option is to go and buy a solution from a provider,” he says. “Then it is cost, it is integration, it is finding the right provider. These are the things firms are facing.” 

While significant efforts are under way at most major firms, and regulators are watching closely, there are rumblings that these rules could change. Speaking at the Fixed-Income Leaders Summit in Amsterdam during October, Kay Swinburne, a UK Member of the European Parliament, lamented the final state of such rules, and suggested they may come in for scrutiny during the Mifid II review.

Brexit

One of the big unknowns in 2019 will be Brexit and how it will impact Mifid II. “We are now looking at Mifid III. I think there is fine-tuning on both sides that will obviously come into play as part of the Brexit negotiations,” says Liquidnet’s Healey.

She says that ultimately, it is going to depend on how it plays out in terms of whether the UK gets an equivalence agreement, which would allow firms operating under UK law—while distinct from EU law, albeit almost identical—from the point of departure to interact under their home regime with EU entities. As an example, she points out that 40 percent of the SI market is based in the UK. 

“There are elements of Mifid that will be impacted. The extent to which they will be impacted will ultimately depend on the final deal that we get. It is just important that firms actually look at making sure that they have contingency plans in place, under which they can continue to trade regardless of the outcome,” says Healey. Indeed, regulators are currently undertaking extensive efforts to sign memoranda of understanding to facilitate data sharing in the event of a no-deal Brexit (see page 10).

Looking ahead, however, it is unlikely that anything will change in the short term. While Mifid II, like any European regulation, has a built-in review clause that kicks in three to five years down the line, the fact that the UK regulatory authorities were principal authors of much of its content—and, indeed, have gone further than the text in many instances of domestic implementation—means those hoping for a swift dismissal of Mifid II may be living in a fantasy world.

“I don’t think we are going to see a regulatory big bang, if that is what some may have thought would happen,” says ACA Compliance’s Johal. “The UK was a very powerful player in devising and pushing forward many of the changes in Mifid II. In fact, many of the changes across many of the European directives have been in operation in principle in the UK for many years before they became European directives. So the UK is a very well-developed, very well-established landscape for financial services.”

As this issue went to press, the UK and EU had agreed a draft deal in principle, but no certainty of its ratification was evident, which included equivalence determinations for the UK during a transition period while it leaves the EU.