Markets in Financial Instruments Directive (MiFID) has been described as pure cost pain for little liquidity gain by some. What might the impacts be for the financial services firms in terms of conduct of business, data management and best execution and order-handling processes? asks Dr Anthony W Kirby, Fellow of European Think Tank Promethee and Founder RDUG.
The Markets in Financial Instruments Directive (MiFID), which is due to be implemented across the European Union by April 2007, will apply to all financial instruments and investment advice exchanged across every EU-member state. MiFID replaces the Investment Services Directive (ISD), which was originally adopted in 1993, but in contrast to ISD, is a highly prescriptive directive, which leaves little room for interpretation.
As a result, simultaneous changes to client classification arrangements and agreements, conduct of business, outsourcing, best execution, order handling, pre- and post-trade transparency, transaction reporting, and recordkeeping are all possible. It is not an overstatement to posit that MiFID’s implementation could reshape the face of the European markets as we know them.
The impact will be felt most keenly in the front office, particularly under the best execution and order execution policies, as well as the data transparency requirements. It will, however, result in an impact on the reference data business in handling the additional data feeding into middle and back office processes, instrument classifications, client data, and other areas.
The objective of MFID is akin to ISD because it supports a harmonized single European financial services market so that any regulated entity can “passport” itself into any other EU-Member State (enabling them to sell their products and services such as investment advice throughout the EU without re-authorisation) – a kind of “think local, buy European” approach to transacting.
Politically, MiFID is also an important foundation for the creation of the single liquid market in financial services by 2010. In contrast to ISD though, MiFID’s scope is much more inclusive. MiFID expands the definitions of financial instruments to include other frequently-traded instruments, including contracts for difference (CFDs) and other types of derivatives such as credit, commodity, weather and freight derivatives.
Market-led solutions powered by managed market, reference and classification data architectures will be particularly in demand to help practitioners transition to the post-MiFID world. This is because MiFID will result in fundamental changes to the way in which investors, investment professionals, market professionals and markets operate.
For example, MiFID’s goal of enhancing market transparency in order to offer better protection for the end investor could unleash a flood of market, reference and classification data. This data will need to be published, harmonised and managed against very stringent timeframes. This could result in serious dislocations for many mid-sized firms not least because MiFID compliance is being single-threaded on from other broad-span directives such as the Savings Directive (EUSD) and the Capital Risk Directive (Basel II). The additional fact that the data structures within firms may require overhaul.
The upside of MiFID is that it should catalyse the replacement of antiquated links between markets which have enjoyed the monopoly of the concentration rule, strengthening market linkages to provide immediate access to the national best bid and offer in a manner somewhat akin to the NMS in the US.
If all exchanges could provide automatic execution, there could be a pseudo national market limit order book, forcing all marketplaces to attract orders by competing on fees, better service, and trading enhancements in a more transparent manner. MiFID could thus catalyze important changes in the way that firms choose to behave, representing a step-change in the workflow and data-handling for firms wishing to continue to do business in the EU-25 member states.
There are several significant challenges too. As of June 2005, many firms had yet to determine the likely impacts on their front offices with regard to client interactions, trade sizes, volumes, prices or volatilities. This represents significant opportunity cost, because the timeframes to make changes to systems, databases and workflows is extremely challenging, even with a delay of one year.
Initial readings suggest that trade volumes could increase three to four-fold as more firms take advantage of electronic tools at their disposal to facilitate direct market access or algorithmic trading when slicing up their orders or portfolios into smaller clip sizes. A further challenge will be to link innovations in the front office to allow the middle and back office to develop innovations in risk and liquidity management to match.
If there are key changes to make to customer, order, execution and transaction management systems, the monkeys are likely to be on the backs of the market infrastructure entities and the sell-side firms because they are likely to shoulder the majority of the spend to get the job done.
Firms will need to make strategic choices – in relation to their core competencies, their competition, the service lines they operate and their future strategic imperatives. For example, if margins are challenged and the investment banks less inclined to commit capital to grant immediacy on account of greater transparency, this may force some firms to contemplate whether they want to exit the business. This could be true particularly for smaller and medium-sized entities who have neither the economies of scale nor the investment wherewithal to play in the game.
There will be important obligations with regard to Conduct of Business relating to client agreements. Existing Know Your Customer (KYC) provisions will need to be extended so that the investment firms offer appropriate products and information on potential risks to their clients on the basis of suitability tests.
For example, under Article 19.4, firms must perform the necessary due diligence to obtain the necessary information regarding their client’s knowledge and experience to recommend suitable services and instruments in their documentation. Under reciprocal Article 19.5 – their clients must provide evidence regarding their knowledge and experience via two-way client agreements which will need to be recorded. The success of this undertaking will depend on common client classifications and this common reference data elements and counterparty hierarchies.
Also impacting reference data is that under MiFID, order execution policies will need to include information on the different execution venues (where the investment firm executes its client orders and the factors affecting the choice of execution venue). What might ‘Best Execution’ look like in a fragmented liquidity environment comprising exchanges, automated trading systems (ATSs), multiple order management systems (OMSs) and internalised matching? CESR believes that firms must have scope to make judgements about how best to address implicit costs. This in turn would require the assimilation, storage, distribution and publication of a potentially massive expansion in volumes of data – relating to market, reference and derived data. Three to five-fold increases are foreseen by some observers.
Given the span of these impacts to financial systems and practices, it is little surprise that the jury is out on the end cost of compliance across the industry. More exact business impacts will need to await the publication of the final consultation papers during the Level 3 processes later this year.
For investment banks who would likely contribute to 70% of the likely end costs, the strategic and operational impacts across hot-spot areas such as best execution, order handling, pre-trade transparency, post-trade reporting and recordkeeping would amount to several millions of dollars per firm per year, with extra costs likely to arise where firms service exotic or alternative products such as OTC derivatives, CDSs/CDOs, collective investment vehicles or investment advice. If this is extended across the 5000 or so firms likely to be impacted across the EU-25, the total bill could exceed EUR1-2 billion per annum. This would probably represent a lower order of magnitude compared with spending behind the conversion to the Euro, preparations for Y2K, or the projected spending behind Basel II provision. Exact costs will become more apparent during the months ahead as practitioners, consultants and the rest of the industry club together to evaluate the impacts.
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