Europe’s big bang of market reforms, known as Mifid II, is approaching faster than the financial services industry would like.
A major piece of post-crisis legislation, Mifid II aims to strengthen protection for investors and inject greater transparency into markets. From asset managers to traders, brokers, banks and exchanges, everyone is having to prepare for a new regime that comes into effect at the start of January.
The new rule book already stretches to a mammoth 1.4m paragraphs, but will only lengthen because regulators are still drafting rules with just 130 days to go. Here are three of the biggest outstanding issues facing investors and trading venues.
“Mifid II’s long gestation period is almost through but the EU institutions are treating it like we’re not completely pregnant,” says Sam Tyfield, a lawyer at Vedder Price in London.
1. Equivalence decisions . . .
As Mifid II looms, a priority for investors is that European regulators need to recognise which other countries have rules they judge to be equivalent. The practical effect of doing so will be that EU-based institutions can buy or sell a security on trading venues outside the EU, while at the same time enabling foreign-based investors to trade in the single market.
Without a determination from regulators on equivalence, EU-based investment firms will be forced to use European-listed instruments, even if there are significant disadvantages in doing so. Fund managers, for example, would have to buy or sell shares in Google parent Alphabet or Amazon via their less liquid listings in Frankfurt, rather than the main listing on the Nasdaq in New York.
“We estimate there are more than one hundred trading venues we have to sign off to do the same business we already do today,” says James Baugh, head of European Equity Market Structure at Citigroup.
The European Commission insists it is focused on making determinations on jurisdictions that most affect EU markets, which puts the US at the top of the list. The first authorisations may come as early as September, but there is anxiety that regulators are cutting it fine.
2. The trading obligation . . .
It is dull sounding, but the question of the “trading obligation” is critical in defining how significantly Mifid II will affect the over-the-counter (OTC) swaps market. Designed to meet a post-crisis commitment by G20 countries to alleviate systemic risk, the regulation requires that certain standardised and liquid derivatives be traded on an electronic marketplace.
The aim was to transform trading in swaps, which everyone from pension funds to corporates uses to hedge things such as interest rate and currency risk, from one in which most deals were privately negotiated between banks to a more exchange-like market.
It is now the job of the European Securities and Markets Authority (Esma) to determine which swaps will qualify, and thus be subject to tougher pre- and post-trade transparency requirements. While the regulator currently drafts final technical guidance, the proposals it has shared with the market have already revealed significant issues.
Firstly, electronic market makers such as Citadel Securities argue that Esma’s current proposals mean most of the $273tn market for euro, sterling and US dollar interest rate swaps is illiquid, and therefore not subject to Mifid II.
Complicating matters, Esma’s judgments on what should and should not be traded on exchanges are far narrower than those already made by US authorities. As Citadel Securities notes, the “liquidity profile of an instrument does not drastically change based on geographical boundaries”.
If the gap in the European and US determinations persists, many fear a fragmentation of markets that will ultimately mean more business moves to the US.
Finally, asset management lobby groups such as ICI Global have voiced worries around how so-called packaged transactions will be treated under Mifid II. These are deals involving two or more components, contingent on each other and executed at the same time. Many regulated funds rely on such deals to execute investment strategies.
Under Mifid II, if one part of the transaction has traded on an electronic venue, then the rest must follow. As the clock ticks down, asset managers are asking for Esma to be given the powers to grant exemptions.
3. Systematic internalisers . . .
These are rules intended to clamp down on the volume of trading in shares that banks execute away from exchanges, or on so-called dark pools. European policymakers want more of this trading to move back to exchanges, reversing a trend that has seen the share of European equities traded on dark pools rise to 12 per cent, from less than 2 per cent in 2010.
This ambition has made a little-used legal status for trading venues known as a “systematic internaliser” (SI), a vexed issue as the final Mifid II guidelines are written.
The status, which is currently available but not widely used, allows institutions to trade shares off-exchange but is more lightly regulated. Standards around minimum quoting, for example, and trading increments — or tick sizes — and trade reporting are all eased.
Tim Cave, an analyst at Tabb Group, a capital markets consultancy, estimates that up to 20 operators will have the status in January. Goldman Sachs, JPMorgan, Morgan Stanley, Mizuho and UBS, as well as proprietary traders Sun Trading and Virtu Financial, are expected to be among them.
However, policymakers in Brussels are now worried that Mifid II rules contain a loophole that will spur the creation of private off-exchange networks for share trading. They want to rewrite some rules and are weighing feedback from a market consultation. An update may come as early as late August. Market participants won’t need to fully comply with the rules for a year.
“Even though regulators may act swiftly to limit the growth of SIs, the blueprint they will create of more tailored liquidity pools will be here to stay,” says Mr Cave.