Good Intentions, Bad Results in Europe?
December 5, 2011
The second iteration of the European Markets in Financial Instruments Directive is supposed to fix what was wrong with the first version, adopted in 2007.
The first edition was intended to increase competition among trading venues and visibility into prices. It accomplished the first goal by generating a whole lot of alternative trading platform to rival incumbent exchanges. But it didn't exactly accomplish the second and there are lots of new players following disparate policies.
"The MIFID II directive's central aim is that all organized trading is conducted on regulated trading venues with increased pre- and post-trade transparency requirements to ensure a level playing field, providing greater clarity on market access rules and levels of responsibility among both venue and broker alike," said Rebecca Healey, senior analyst with research firm Tabb Group in London.
The good news: the phrase "all organized trading"-refers to not only trading in equities, but corporate bonds and over-the-counter derivatives which were largely forgotten when the first version of MiFID was first introduced.
MiFID II will also have more teeth than its predecessor. While national regulators could interpret the first version of the directive as they wished, the newly created European Securities and Markets Authority (ESMA) will have the final word on creating uniform rules for how the legislation will be applied. The expected deadline is 2014.
The bad news: MiFID II might actually do fund managers a lot more harm than good. Just one example: if fund managers use algorithms to execute their trades they might be forced into being market makers and be forced to make trades that at times are not profitable to them.
"Fund managers will likely experience reduced liquidity and wider spreads, which would increase their implicit trading costs," predicted Robin Strong, director of buy-side market strategy in London for Fidessa, a provider of high-performance trading, investment management and information software.
Indeed, about 44% of the European fund managers surveyed by Tabb Group take the same view, according to a report to be issued by the research firm shortly.
One of the key pitfalls of MiFID II, as now envisioned, is in how it defines high-frequency trading and algorithmic trading.
Algorithmic trading, said the EC, occurs when "a computer algorithm automatically determines aspects of an order with minimal or no human intervention." High-frequency trading is a subset of algorithmic trading where a trading system analyzes data or signals from the market at high speed and then sends or updates large numbers of orders within a very short time period in response to that analysis.
"At one point, it seemed that the regulators might categorize algorithmic trading done by high-frequency firms and the algorithmic trading done by traditional fund managers in one broad sweep," said Richard Balarkas, chief executive of agency brokerage Instinet in Europe. "They aren't the same."
The European Commission may eventually back off from blurring the lines between the two but as it now stands, all financial firms engaged in algorithmic trading must also post competitive prices-bids and asks-continually throughout the day regardless of market conditions.
That's a big change from the current practice where makers typically use algorithms that are triggered by specific market circumstances and are not automatically active during trading hours. "Firms that use high-speed market-making algorithms may actually decide to reduce their trading activities rather than trade in potentially unprofitable circumstances," Healey said.
MiFID II also tries to establish some common oversight among exchanges, multilateral trading facilities and broker systems that internalize trades as well as largely unregulated broker crossing networks. Broker crossing networks, when not registered as systematic internalizers or multilateral trading facilities, would fall under a new catch-all category, called OTFs, or organized trading facilities.
The OTFs would not be able to match customer order flow against a broker's internal order flow; such a facility could only match customer order flow against other customer order flow.
The OTFs will have to follow the same pre- and post-trade transparency rules as regulated markets and multilateral trading facilities. That means they will have to report trade executions in real-time, although national regulators could decide which trades are eligible for deferred publication based on their type or size.
The problem: "Brokers are permitted to operate multiple liquidity pools for the same asset class; however this results in further fragmentation of liquidity with customer orders in an OTF unable to be crossed with the broker's internal flow even if it would result in price improvement," Strong said. "The increase in fragmentation makes it harder for the buy-side to execute institutional order flows while fulfilling their best execution requirements."
The confusion surrounding the definitions of OTFs and MTFs has led the EC to issue a questionnaire seeking comment by Jan. 13 to determine whether the new category of OTFs is even necessary.