MiFID, MMT And European Market Reform
By Arjun Singh-Muchelle, Senior Adviser, Regulatory Affairs, Institutional & Capital Markets, Investment Management Association
It was a bright cold day in October 2011 as the clocks were striking 10:00 when MiFIR/D II was unveiled by Commissioner Michel Barnier.
Over two-and-a-half-years later, on an equally bright and cold afternoon in April 2014, the European Parliament finally voted through the Level-I text of MiFIR/D II. There is a lot in the legislative proposal that will go some way to ensure stability in the market; restrictions on high frequency trading; stringent rules on market abuse; introduction of equivalent treatment of investment and insurance products and ensuring a high-level of investor protection.
High-level investor protection
The EU Parliament’s confirmation that key investor protections are to be extended to insurance-based investments and structured deposits is very important and will benefit investors widely. We have always maintained that having different disclosure and conflict regimes, simply because some products were historically classified as insurance-based or deposits and not seen as investments, failed to look at the issues through the experiences of investors and savers.
By 2017, most of these differences will have gone. The PRIIP KID Regulation, in particular, will ensure that investment funds, insurance-based investment products and structured products will all have similar pre-sale disclosure requirements and this could come into force as early as late 2015.
On the issues regarding capital markets however, asset managers, as fiduciaries for their clients, have doubts on whether MiFIR/D II will ensure efficiency and free and fair competition in financial markets. Before going in to the details, one point needs to be made up front: asset managers only ‘trade’ on the market as fiduciaries and as agents; that means, they do not trade on their own behalf, but rather, have a legal and contractual obligation to manage assets in the best interest of their clients (the vast majority of whom are long-only, unidirectional funds such as pension funds). It is their legal responsibility as fiduciaries therefore, that has framed our thinking and positions on MiFIR/D II.
The contentious ‘dark pools’
Were one to call a spade a spade, these pools would be called by their more representative name – ‘institutional liquidity pools’ – for that is their purpose; providing institutional investors with an alternative liquidity pool.
The underlying assumption of the volume cap mechanism is that there is no difference in the needs of global institutional investors and Mrs Jones, who may invest €200-a-month. For the seasoned market watcher, this is utterly ridiculous.
The proposed volume cap mechanism limiting the ability of asset managers to trade in institutional liquidity pools will have a negative impact on the equity market, which was not a primary cause of the financial crisis. The restriction on the use of these pools limits investors’ abilities to trade what are often illiquid or bespoke trades. The cap will force these trades on to primary exchanges where they will face the adverse effects of having to trade with competing traders who will be able to see them coming. This will increase transaction costs for investors and make it more expensive to trade.
It is always important to recall that these pools allow investors to reduce the market impact of their trade and therefore the associated transaction and execution costs which benefit the end client. Research by LiquidMetrix has shown that these pools (in February 2014) offered an average price improvement of 14.21 basis points when compared with the best lit venues across Europe.
As such, the IMA is calling for a phased-in implementation to the volume cap mechanism. On 1 January 2017, make the most liquid asset classes subject to the volume cap. On 1 June 2017, make the less liquid asset classes subject to the cap and finally, on 1 January 2018, make the remaining, least liquid asset classes subject to the cap. It is our view that a tiered, phased-in approach is necessary to mitigate any and all adverse effects of the volume cap mechanism. As order sizes and depth across primary exchanges have dramatically declined in recent years, the choice to trade blocks in such pools has become (and will remain) increasingly important.
In trying to increase access to market funding for SMEs in Europe, the volume cap mechanism achieves the opposite. In fact, all of the top 15 names hit hardest by the volume cap are listed on the FTSE 250 and FTSE Small indices. Since over 90% of European equities trade on primary exchanges with only a small proportion of the European equity market (9.46% in February 2014) traded in institutional liquidity pools, we have always maintained that post-trade transparency is more of a major concern than pre-trade transparency for asset managers. This is why the IMA has officially endorsed Market Model Typology (MMT) as the minimum standard for post-trade transparency.
Market Model Typology
MMT will take the various post-trade flags from the different European exchanges and convert them to a single, unified post-trade language. This way, a risk-less principal trade on Euronext will be converted to the same post-trade flag as a risk-less principle trade on the LSE. By creating such a harmonised standard for post-trade transparency for the European equities market, MMT will be the first step towards achieving a consolidated tape across Europe.
The largest failing of MiFID I in relation to markets was the lack of a consolidated tape in Europe. Asset managers have been promised such a tape for decades but neither regulators nor data providers have delivered. MiFIR/D II does very little to solve this failing. The new legislation has split the tape requirements into two; one tape for equities and another for fixed income. The earliest asset managers will have these tapes however, is not until 2020.
It is not just the equity market that will be affected by these rule changes. Fixed income markets will also face significant structural changes.
The European bond market is already relatively illiquid, with liquidity concentrated in primary issuance with a rather shallow depth on the secondary market. The pre-trade transparency requirements for these markets will have a detrimental impact on the already scant liquidity. The implementation of the pre-trade transparency requirements for fixed income therefore, needs to be treated with caution. Mis-calibrated pre-trade transparency requirements may have (and probably will have) a disruptive impact on the fixed income markets.
Efficient calibration of post-trade transparency, of what has actually occurred in the market, is far more important (and useful) to investors, rather than pre-trade information that may have no bearing on market realities.
Finally, to the ‘flash boys’.
A lot has been written about high-frequency traders. But speed is not in itself a bad thing. In fact, during times of severe market stress, speed is vital. There is however, a big difference between those who use algorithms to trade (such as asset managers who may use Order Routing Systems) and those proprietary traders who depend on high frequency algorithms to exploit minute price differences in very small size of trades. The latter of these is unhelpful. As liquidity takers, proprietary high-frequency traders may make effective and meaningful bid-offer crosses difficult for asset managers.
Primary exchanges aren’t off the hook here, either.
Through generating revenue from allowing high frequency traders access to primary exchanges, the latter are contributing to the problem rather than equally participating in mitigating any adverse effects that arise from the prevalence of ’fair-weather liquidity’. As with most financial legislation however, much is left to the European Securities and Markets Authority (“ESMA”). With over 100 regulatory technical standards and delegated acts that ESMA will need to draft and the European Commission to adopt, ESMA is facing a rather large task. ESMA however, has limited resources and a small number of staff. This will make it all the more important to make full use of the information that market participants can provide.
The IMA is working with other trade associations from both sides as well as a number of trading venues to ensure that we are, collectively, able to assist ESMA by providing it with the data and evidence it will need to ensure the effective implementation of MiFIR/D II.
A lot has been said about the delicate balance to be struck between stability and efficiency and free and fair competition on the markets. However the two go hand-in-hand so it is a false comparison.
Through creating efficient markets that engender free and fair competition between all actors, whilst putting in place stringent rules on market abuse, axiomatically leads to stable markets. Together they generate economic growth and development.