The Frustrating Wait to see Effects of MiFID II

After a multitude of articles on the policy objectives of MiFID II, the new obligations of the buy- and sell-side on research and trade reporting, and the new requirements for transparency in fixed-income markets, Thomas Murray finds itself in the position of having to see how trading begins to adapt as the Directive comes into effect at the start of the year. Specialising in post-trade infrastructures and services, its business lines are not in the immediate lines of fire of this reform – its clients are, but in other of their activities.

The authorities with whom we have spoken caution that the new shape of the EU capital markets will not take form immediately, judging from how long it took to see with any certainty recurring patterns in trading after the implementation of Regulation NMS in the US and MiFID I in the EU. We have been advised to expect a period of 12-18 months in which time the order flows and ways of execution will have settled under this new regime, assuming that this adaptation is not unduly thrown off course by world events, unforeseen technological changes, and of course economic and financial changes that would alter significantly today’s outlook on trading and investment conditions. This truly is a complex mix of variability, one which does not give even the keenest of observers a clear view ahead.

Thomas Murray has prepared a strategic response as from 3 January 2018, as the concluding section of this article notes. The frustration is that the firm would want to have been more proactive for some time already than this uncertainty allows. Until then and for a good while afterwards, there will be a long period of “wait, observe, analyse, and act.”

The front-line changes

This reform requires a different kind of preparation. From the start on 3 January, Thomas Murray will be monitoring key aspects of the Directive and its accompanying Regulation, MiFIR. The waiting means active watching of several aspects of this new environment, most notably:

  • Best execution
  • Trade reporting and transparency
  • Market structure

Even more than in the past, “best execution” will come to have multiple meanings and nuances. Executing brokers will have more onerous responsibilities and detailed reporting to demonstrate their actions on behalf of clients to the authorities. This is no longer just the best price that could be found at the time the order was given, for however long it takes the broker to compete the order. That has been a feat for some years already, given the multiplicity of order execution platforms and the difficulties of seeing across them all as they rapidly adjust for variations in their individual order books.

The new jargon in the market seems to be “the client best execution experience.” To our ears, an experience is composed of many parts: the buying and selling of securities and contracts has become a yet more varied thing. Some authorities expect much of today’s exchange business to be handled in periodic auctions, and also moved to systematic internalisers. Further, in an attempt to force transparency in trading, the EU is imposing dark pool limitations in terms of percentage of trading that can be conducted on them – some industry leaders expect that, for certain securities, limits will be hit at the start of the year, leading to a 6-month halt before recommencing. For those accustomed to continuous trading, this aspect of the Directive is simply bizarre. The further complication is that these halts on dark pools will be hard to calculate. Taking the point to its logical conclusion, one expects the liquidity for executing orders in mid- and small-cap equities to be hit the hardest in this new environment – precisely the corporate population the authorities have said they want to come list on the public markets.

Trade reporting and transparency are, logically, critical objectives for the regulators who oversee “orderly markets.” Better information brought back into the market by regulatory fiat on who is doing what might, at least in theory, encourage yet more trading interest. That would be a good thing.

In discussions with practitioners, however, the current reality seems to disappoint: with all the running around even now to get Legal Entity Identifiers (LEIs) issued, it does seem apparent that those required to do so will not be ready when the starting gun is fired. Here the authorities are expected to be somewhat more indulgent, so long as the parties slow off the mark have been demonstrating goodwill and are getting underway in setting this up. But the other aspect of trade reporting that does not seem evident is what the mountains of data to be collected will actually say – who can read them? As regards the formatting of the data, and exactly what is reportable, the detailed rules do not yet seem evenly fixed across the EU. In this same vein, the regulators are still sorting out the requirements for the reporting of OTC derivatives to trade repositories, and TRs have been years in the making and remaking, not to mention what this trove of data is actually worth. No one has seriously opined as to when the new trade reporting requirements on the EU markets will begin to give valuable new insights into daily market activities.

Over a period of some years as these new data sets are created, scrubbed, and finally made usable by the market, there will be far more information to analyse. This will also affect “the best execution experience.” Brokers will have to be rebuilding their ways of working, because ultimately their handling of orders may become more comparable and competitive.

If best execution is moving, and trade reporting and transparency are very much a work-in-progress as to what those qualities may end up bringing to the marketplace, and when, one must note one other fundamental part of the system that is about to move. Relicensing is encouraging more actors to become what is known in EU jargon as Systematic Internalisers, giving these firms different rights and responsibilities in the execution of client orders.

Those first few months of life under MiFID II

While waiting, Thomas Murray will be watching price formation – what is happening on exchange, in dark pools, and with Systematic Internalisers? Are bid-ask spreads staying narrow or widening? Is liquidity getting yet more concentrated on the larger markets and the bigger issues? What is happening to average trade size? Is it more difficult to see introductions and secondary issues completed?

Price formation is critical to Thomas Murray clients post-trade in the following critical business areas:

  • Repurchase agreement pricing
  • Securities borrowing and lending pricing
  • Collateral valuations for asset pledges
  • Values and asset quality for initial and variation margin
  • Liquidation periods for collateral when an infrastructure may be stressed

The waiting and watching for MiFID II’s effects on European Union capital market activities are not going to make for an especially tranquil start to the new year. Thomas Murray has an obligation to inform its clients as to what it will be monitoring, and it is these few elements and for those reasons. It would be rash to do more, and unwise to think that doing anything else would ease our clients’ adjustments.

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The author, Thomas Krantz, is Senior Advisor, Capital markets, in the firm of Thomas Murray; and served as Secretary General of the World Federation of Exchanges (2000-2012). The views expressed are his own, and not necessarily those of the firm.

Tags: MiFID IITrade Reportingpost-tradeCapital MarketsRegulationRegulation NMSMiFID IMiFIRbest executiontransparencyLegal Entity IdentifiersLEIsOTC DerivativesTrade Repositories

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