LIKE the clubs it sometimes resembles, the financial industry tends to discriminate against non-members—such as bank depositors, retail investors and small firms. The most pervasive form of discrimination is opacity: it is nearly impossible, say, for an average investor to know how much of the money in his pension pot is lost in transaction costs. As well as helping institutions milk their clients, opaque markets can cause or exacerbate crises when investors flee risks they cannot assess; witness the fate of mortgage-backed securities in 2007-08. So it is welcome that much post-crisis financial regulation aims to make markets more transparent. That was true both of the Dodd-Frank reforms in America and a huge new law in the European Union. As with Dodd-Frank, however, the benefits of Europe’s reform risk being drowned in its complexity.
The Markets in Financial Instruments Directive (MiFID 2), which comes into force in January, is a child of the crisis, and is at least as broad and ambitious as Dodd-Frank. It recasts a law from 2007 governing share trading and is the latest stage in the EU’s long project to harmonise financial markets within its borders—this time covering bonds, derivatives and other instruments as well as equities.
Trading in bonds and derivatives is at present largely conducted “over the counter” (off centralised exchanges). The new law pushes it towards electronic-trading venues, and requires much greater price transparency. In the same vein, it restricts trading of shares in “dark pools” (private exchanges closed to the retail investor). The result should be that middlemen pass more of the benefits to their customers. Similarly, investment banks will be required to “unbundle” the cost of their research notes. Fund managers will have to pay for them separately, rather than bury them in other commissions and fees.
Laudable as the law’s aims are, its implementation is proving a nightmare as the deadline draws near (see article). The financial industry, for all its predictable grumbling, has partly itself to blame for leaving preparations too late. But regulators are at fault, too. Some EU countries have not yet finalised their interpretation of the rules (despite Britain’s impending Brexit, its regulator is in fact the best prepared). The precise scope of a new regime for firms trading on their own account, central to the law’s operation, was not nailed down until August.
Liberty, fraternity and equivalence
Most worrying are the looming cross-border clashes. The EU’s rules conflict with American ones that forbid charging institutional investors for research and on investor protection for some derivative transactions. Some measures may do more harm at home than abroad. The law requires EU regulators to declare foreign trading venues “equivalent” for Europeans to continue to trade there. No such declaration has yet been made for America. That may be because any decision made on “equivalence” now might set a precedent for discussions with Britain as it leaves the EU. Even a temporary loss of access for Europeans to the most liquid markets—shares listed on the NASDAQ exchange, say, or futures traded on the Chicago Mercantile Exchange—could do them serious damage.
Like Dodd-Frank, MiFID 2 is a sprawling law that attempts to be an all-purpose instruction manual covering every eventuality. This distracts from the truly important goals and makes unintended consequences more likely. Its predecessor, MiFID 1, for instance, succeeded in its aim of breaking the monopoly of national stock exchanges by encouraging the formation of new trading venues for shares. But that fostered the growth of dark pools. Now, the hassle and expense of compliance required by MiFID 2 may prompt consolidation in trading venues, reversing some of those gains. And, unless EU regulators resolve their clashes with their American counterparts, some parts of financial markets risk balkanisation.
In an ideal world, MiFID 2 would have been simpler, leaving more room for regulatory discretion. Cross-border problems could have been avoided through greater international co-operation earlier on. But now that the law is just around the corner, options are limited. Its introduction was already delayed for a year; a further delay would reopen a can of worms.
Better to introduce the law now, but show regulatory flexibility, allowing a transition period in which investors still have access to American exchanges even if formal “equivalence” is not finalised. And MiFID 2 comes up for its review in 2020. At that point, the European Commission should be ruthless in scrapping or changing bits that are not working as planned. Financial firms, for their part, need to move beyond grumbling. The new law is not just a burden, but an opportunity. It heralds the most transparent markets Europe has ever known.
This article appeared in the Leaders section of the print edition under the headline “A new law heralds a new era for Europe’s financial markets”