10.12.2012
By Terry Flanagan

Implications of MiFID II for the Buy Side

With the creation of ever more trading venues and a more diverse clearing and settlement arena, costs and risks for the buy side in Europe are escalating.

The Markets in Financial Instruments Directive, or MiFID II, which is a comprehensive review of the financial services landscape in Europe, had been hoped to ease the pain for many on the buy side brought about by the original MiFID document in 2007, which had the intention of harmonizing European markets but, in the end, caused huge change and fragmentation to the marketplace.

The original MiFID was meant to open up European equity markets while affording a significant degree of protection for investors. Despite some success, MiFID I could not keep pace with rapid developments in markets and trading systems fueled by advances in technology and increased innovation in financial products.

And the buy side has many issues with its successor, too, and is hoping that last-minute fine tuning will take place to make MiFID II slightly more palatable.

One of the biggest gripes from the European buy-side community is the lack of a consolidated tape. MiFID II has provisions in it to finally create a consolidated tape, or system of record for the market so that market participants can have an easily accessible and transparent view of the market to understand whether or not best execution requirements have been met.

An increasingly fragmented marketplace in Europe, caused in part by the original MiFID review in 2007 which increased competition to the exchange landscape, has made it harder in recent times for buy-side firms to gain a complete view of the market at a reasonable cost. It is estimated that a full set of equity market data costs eight times as much to acquire in Europe as it does in the U.S., which has a consolidated tape in place.

Paul Squires, head of trading, Axa IM

Paul Squires, head of trading, Axa IM

“When we first started talking about MiFID II nearly all the buy side said we need a consolidated tape as a priority,” Paul Squires, head of trading at Axa Investment Managers, a French-headquartered buy-side institutional investor, told Markets Media last month.

“I can’t believe we are still talking about it. We got to a point where that seemed to be progressing and I think we all kind of stopped talking about it and got on with our day jobs as we thought it was going to happen. Unfortunately, that looks to have stalled for some reason.”

Initiatives to put a consolidated tape in place have been batted away by the incumbent national exchanges in the past who are loathe to lose the revenues on offer for use of their market data. MiFID II is currently proposing a commercial competitive approach to the development of a European consolidated tape, instead of a process to pick a single provider or one mandated by the European Union, but it may be one of the provisions that fails to make the final cut.

MiFID II is also looking to crack down on dark pools, which are used heavily by institutional traders.

Many on the buy side are fearful of the removal of broker crossing networks, which MiFID II is doing away with. Institutional traders prefer BCNs over multilateral trading facilities, on the whole, as BCNs can exercise control over the type of flow that can access it. MTFs, on the other hand, generally cannot differentiate between market participants and high-frequency traders—which institutional traders fear as they can very easily move the market against their block orders—are allowed on these venues.

The third exchange definition, apart from the main regulated exchanges which are now dominated by HFT, in MiFID II is that of systematic internalizer. This, too, does not quite help the needs of the buy side as it means the continuous quoting of prices, or market making, which does not allow the BCN operator to unwind risk trades already executed. SIs can also incentivize ‘quote stuffing’ from HFTs, which is illusionary liquidity.

While dark pool MTFs, such as Liquidnet, a block trading dark pool MTF that caters solely for institutional traders, could also be hit by MiFID II.

Some MTF dark pools, such as Liquidnet, currently fall outside the pre-trade transparency regime by virtue of waivers, and while the MiFID II document says that the current framework is still valid, some improvements could be made. For instance, Liquidnet is worried that MiFID II will increase trading costs for its institutional investor clients. Liquidnet operates differently to most other MTFs with its focus on big buy-side institutions.

Plans in MiFID II to publicly display stub orders, the enforcement of pre-trade transparency for actionable indications of interest and the possibility of imposing a minimum size threshold for those, like Liquidnet, using the ‘large in scale’ reference price waiver may mean significant alterations to Liquidnet’s business model.

“Liquidnet believes that the European Commission’s intention of requiring the disclosure of stubs which do not meet a certain threshold would severely disadvantage institutions making large block trades,” said Liquidnet in a MiFID II position paper.

“Requiring disclosure of that order’s remainder, the stub, could give information to high-frequency traders and other short-term traders that there is additional supply or demand in that stock. They can use this information to disadvantage institutional buyers and sellers, which ultimately harms the individual long-term investor.”

Standard Life Investments, a U.K. buy-side institution, concurred: “We suggest that no change is made in the treatment of order stubs. If stubs were forced onto the lit market it would make the crossing of blocks far less likely and would drive execution costs higher.”

MiFID II ideally wants to see pre-trade transparency applied equally to all venues in the future. Under the current MiFID rules, the ‘large in scale’ reference price waiver allows investors to forego pre-trade transparency requirements as long as stock prices are based on a reliable reference price.

“The proposal to impose a minimum size for a reference price waiver would restrict the ability to execute trades at the mid-point,” said Liquidnet. “The mid-point is the best execution price for a customer as it eliminates the ‘spread’ typically earned by dealers and short-term speculators. Mid-point execution is an important component of the cost savings that we provide to our institutional investors. For context, in Europe 90% of our trades are executed at mid-point, providing 100% price improvement to both sides. We fear that imposing a minimum size for the reference price waiver would make it illegal for models such as ours to provide best execution to long-term investors.”

Waivers for ‘large in scale’ transactions are still available in MiFID II, but in order for a regulator to grant a waiver, it must be approved by the European Securities and Markets Authority, the pan-European regulator, first. More details are set to emerge, but there are indications that the EU considers that waivers have been granted too easily so far.

So, all in all, the life of a buy-side trader is set to become much harder as, if MiFID II comes to pass as it stands, spreads will widen, depth will evaporate and there will be fewer places to hide as broker dark pools face restrictions.

However, there is some way to go in the political process in Brussels before MiFID II becomes binding. The European parliament’s Economic and Monetary Affairs Committee draft of MiFID II, which was passed overwhelmingly, will soon be voted on by all MEPs, although this is thought to be a mere formality.

Then the Council of Ministers—with nations such as the U.K. and the Scandinavian countries thought to be vehemently against MiFID II in its current format—will table its own version, likely around the end of November, with input from the European Commission before the three institutions of Europe sit round a table and thrash out the final law, in a process called trialogue. Formal implementation is not expected until 2015.

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