The most anticipated financial event since the birth of the euro has finally come to pass.
The most anticipated financial event since the birth of the euro has finally come to pass. The European Union’s Markets in Financial Instruments Directive came into force on November 1, signalling the end of years of preparation and kick-starting a new era of capital flows around and between EU member countries.
Many financial market participants have no doubt of the benefits MiFID will confer. ‘The European market is really opening up and becoming a single economic area for financial services,’ says Paul Beach, head of corporate and investment banking at Atos Consulting. ‘That will continue and has to be good for investors across Europe.’
The core principle of MiFID, he says, is to increase the transparency and awareness of cost and prices. But Beach believes MiFID is not necessarily driving these changes, and is actually a reflection of what the market had started to do on its own. ‘Although MiFID is driven by regulation, it is actually a market change,’ he says. ‘Hedge funds and other professional investors are driving it, by increasing competition and demanding that brokers pursue best execution strategies.’
Best execution is the one part of MiFID that everyone agrees will have a major impact on the marketplace. Atos principal consultant David Smith says: ‘As the market unfolds, firms will move away from a one-size-fits-all execution policy. Innovating brokers will start to specialise, so order routing capabilities that are attractive to hedge funds will take up the flow. There will be many more venues and more, smaller-sized, trades.’
In the US, there has been rapid take-up of best execution practice to the extent that brokerage is now less to do with personal relationships and more to do with sales based on price. ‘We are heading the same way in Europe,’ Smith says. ‘There will be less need for voice broking as hedge funds look for the most efficient mechanism.’
In fact, the EU legislation has not actually stipulated that brokers find the best price for their clients, but instead prescribed transparency of execution within the agreed service standards. But inevitably, price is what both buy-side and sell-side are focusing on and over which the coming battles are likely to be fought.
However, some brokers have viewed the letter of the law and the slightly hazy stipulation of transparency within service standards as meaning they do not need to make any changes at all. Beach says: ‘Banks are effectively allowed to set their own standard, so many have not changed radically. They are compliant but they have not radically improved their best execution.’
Atos believes they are missing an opportunity to benefit from the changes that MiFID implies. ‘We are seeing more advanced banks moving on from compliance and providing a differential in terms of the levels of speed and execution,’ Beach says. To achieve that, they need to adopt new technology approaches such as smart order routing (SOR) to take advantage of the new venues that MiFID permits. In effect, MiFID allows a whole new range of markets to be created, and it is up to the buy-side to choose the right brokers and the appropriate technology to access the full range of new trading venues.
In this new and more diverse environment, SOR mechanisms are indispensable for speedily checking all the venues that are relevant to the underlying customer and the type of trade. Smith says: ‘Smart order routing allows you to apply all the rules you want to according to client and transaction type.’
The new venues, including systematic internalisers, have existed in the UK for years as London’s position as a major trading centre has provided huge amounts of liquidity for the bulge bracket banks that do business there, but for much of continental Europe, the advent of systematic internalisers will represent a significant cultural shift.
‘The commission wanted to break the monopoly that local exchanges enjoyed in countries such as Italy, Spain and France, and provide pre-trade price transparency,’ Beach says. ‘By law, before November 1, if you wanted to buy local shares you had to trade through the local exchange.’
Estimates for the numbers of systematic internalisers that will be created in the wake of MiFID’s implementation range from four to 400. Beach says: ‘All the institution has to be able to do is to make prices available on an automated basis. They could be on a website or carried by data vendors. That makes for a very open playing field.’
The challenge to the incumbent markets is clear from the intent of a group of the world’s largest investment banks to set up a viable alternative. Turquoise, a consortium comprising Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, Merrill Lynch, Morgan Stanley and UBS, announced at the end of 2006 that it would set up a rival to Europe’s established exchanges, and BNP Paribas and Société Générale joined the group early this year. It is one of several new liquidity providers that are expected to launch in the next six to 12 months.
At the time of Turquoise’s initial announcement, the thought of a serious rival to the European stock exchanges was genuinely shocking. At the launch announcement, shares in the London Stock Exchange fell sharply on concerns that the new platform would divert trading away from it. After all, Turquoise promised to cut trading fees in half.
The rationale for Turquoise is fairly simple: the investment banks that conduct the lion’s share of trading either directly or on behalf of clients were fed up with being forced to pay the tariffs set by Europe’s exchanges and with the refusal of those exchanges to reduce fees. ‘There is a real need for competition in the marketplace for equity execution and venues,’ says Eli Lederman, who was appointed chief executive of Turquoise in October.
The model that Turquoise and others are based on is tried and tested in the US, where trading systems known as electronic communication networks have proliferated since they were authorised by the Securities and Exchange Commission in 1998. ‘ECNs have undoubtedly taken market share away from the incumbents,’ Lederman says.
The success of the US ECNs is predicated on the ‘taker-maker’ model, which Turquoise will also adopt. The model rewards those who make prices to buy or to sell, while levying higher charges on those who take those quoted prices, either by ‘hitting the bid’ to sell or ‘lifting the offer’ to buy.
Providers of liquidity will receive a rebate on their fees as a kind of loyalty bonus for using the platform. Lederman believes this rebate model will be a key weapon in the battle to attract liquidity in a marketplace that could soon include a host of new players.
Another weapon, he believes, will be Turquoise’s use of innovative technology, which he thinks will put the incumbent exchanges’ systems in the shade. ‘There is a question mark over the quality of technology that the incumbent exchanges possess,’ Lederman says. He says Turquoise’s systems will be able to handle greater volumes and provide speedier trading than currently exists.
‘Our latency will be very low – we are talking about small numbers of milliseconds,’ he says. Low latency is particularly important to attract investment bank proprietary trading desks and those hedge funds that use quantitative methods to trade very small market anomalies using large amounts of leverage.
Turquoise will also attempt to meet growing demand for access to shares that are traded between banks in large blocks away from the main exchanges. In the US, ‘dark liquidity pools’ now account for about 10 per cent of equity market trading.
Lederman says: ‘There is demand for a link-up between the transparent order book and the dark order books behind it. Our technology will look for matching between these two venues. That is truly innovative. It means our system works well for small orders, but also for large orders when there is the need for more obscurity.’
Turquoise argues that the combination of cheaper trading, speedy execution and access to previously invisible liquidity will allow it to quickly gather momentum. ‘We think 10 per cent of European volumes is quite feasible and our aspirations are much higher than that,’ Lederman says.
He believes Turquoise will offer the best pricing so, under MiFID’s best execution principles, which compel brokers to offer the best deal to their clients, liquidity will automatically flow to it. ‘Brokers must look for the best price and smart order routing technology means they will scan all venues to find it,’ Lederman says.
But even with the tantalising prospect of speedier trading and reduced fees, many buy-side firms do not seem to have come to terms with MiFID at all, despite the long lead-in period. ‘Some seem to be taking a wait-and-see approach,’ says Richard Jones, chief executive of Fidessa LatentZero.
‘People are waiting to see who will be the first to be caught for non-compliance and then address the areas their rivals were caught for. A number on the buy-side have taken that view. Some of our customers have been very proactive and have dedicated time and detailed thought to the process. Other people have rung us up in the last couple of weeks and asked what impact MiFID is likely to have on them.’
One of the reasons that some on the buy-side have ignored MiFID is that best execution – the central plank of the directive – is not actually mandatory. As Jones says: ‘Best execution is only a requirement when clients require it to be a requirement! If you are a pension fund you will certainly demand best execution, but a hedge fund and its clients may not necessarily require best execution. MiFID does provide more flexibility within the boundaries of best execution than previous regulation by recognising other factors other than price, such as speed and certainty of execution.’
In the case of certain hedge funds, however, best execution even under the new wider definition may be a hindrance to the investment strategy. For example, filling an order at the best price over, say, three days may be far less attractive than trading immediately and having the option to sell the position shortly after.
Nevertheless, around Europe there appears to have been a disconcerting lack of preparation by buy-side firms. According to Celent, a Paris-based consultancy, this could be a big mistake. ‘The buy-side are saying they will believe MiFID enforcement when they see it,’ says Celent chief executive Octavio Marenzi. ‘This is extremely brave, because the regulators are serious about this. They may have to string up a few firms to make an example.’
Some buy-side firms do not believe MiFID applies to them at all, he says. ‘MiFID in fact makes no distinction between the buy-side and the sell-side. It sees them all as investment firms and treats them all the same. It was argued that portfolio management should not be regulated in this way because it is not transactional, but this argument was rejected by the European Commission and the Committee of European Securities Regulators. I think this is right – it is very hard in some cases to make the distinction.’
The buy-side has a number of key areas it cannot afford to ignore in the wake of MiFID. They are compliance-type issues but nonetheless should not be taken lightly. They include client classification: explaining to the different types of clients about execution policy and agreeing the policy with the relevant investor.
In addition, MiFID prohibits the bundling of execution and research in all its many guises. While unbundling is standard practice in some countries – in the UK, the Myners report at the start of this century was forceful in its condemnation of bundled services – in other jurisdictions the practice still exists. Marenzi says: ‘Let’s be clear – soft commissions are going the way of the dodo.’
If buy-side firms cannot bring themselves to take a proper look at the provisions within MiFID, they could also face extinction. After all, if the regulators really want to make an example of directive-dodgers, the fines and penalties imposed could be the difference between making a small profit or a heavy loss in any one year.