Countdown Begins: 21 Months To MiFID
In 1993, when the European Union’s Investment Services Directive (ISD) came into force, it was the largest single change to affect the financial services market across the 15 EU member states. The EU’s Markets in Financial Instruments Directive (MiFID) replaces ISD, which makes it at least equally important. MiFID impacts the 25 members states of the EU, as well as the three EEA countries, which makes the impact even broader. And it affects trading in all asset classes, which altogether will definitely make it the most important change in the last 15 years when it comes into force on 1 November 2007.
Despite the fact that the draft text of MiFID has been available for over two years, and the headlines have hardly changed, most investment firms – both buy-side and sell-side – have still got their heads stuck in the sand about it. One of the causes has been the use of the ‘Lamfalussy Process’, whereby the headlines of MiFID were released first with the details to come later. Only the level 1 text of MiFID has been released so far, and publishing of the draft level 2 text is running behind target. Investment firms are still saying, ‘until we know all the details, we can’t prepare for it’.
Sell-side firms are not the only ones affected by MiFID – buy-side firms are impacted too. MiFID is fundamentally about ensuring that investment firms provide best execution in the interest of their clients. Buy-side firms still bear the regulatory responsibility for best execution, even if they outsource the execution itself to their brokers. If the broker is not able to provide the best deal in the market for a particular trade, the buy-side firm is going to have little excuse for having routed an order to that broker in the first place.
So far, buy-side firms have been noticeable by their absence from discussions about preparing for MiFID. They appear to be unaware of the workload that faces them. It seems reasonable to expect that a major change in the underlying market regulations will require buy-side firms to review and adapt their existing client agreements – even if only to reduce the risks of client litigation. The sheer scale of the task of getting all clients EU-wide to sign off on amendments to agreements is daunting: estimates are that some 80 million investors may be affected. Equally, analysing and comparing broker performance to ensure that the buy-side firm does pick the right one is no small task in itself. All of this is work that could already have been started.
The opinion of MiFID on the buy-side is: ‘It can’t be my problem, but if it is, I’ll make my broker deal with it’. The overall state of preparedness is not much better among the sell-side firms. With some 2,000 member firms of stock exchanges across the EU, most still appear to think that they will be able to carry on with business as usual. Around two years ago the Committee of European Securities Regulators (CESR) drafted its own advice to the European Commission indicating that on-exchange prices could no longer be considered as the benchmark for best execution. With MiFID, it will be hard for a broker firm to tell a client that it only trades on-exchange, as this would be a statement that it is not going out to look for the best deal for its client – and that is contrary to the fundamental principles of MiFID.
The lack of readiness of the sell side has been clear for some time. In a recent survey entitled ‘MiFID Readiness Survey’ which was published by the MiFID Joint Working Group in October 2005, two-thirds of sell-side firms surveyed didn’t have – or didn’t know if they had – a MiFID compliance framework in place. 80 per cent didn’t know if they had a technology strategy in place.
The initial reaction to MiFID is ‘head in the sand’. The second phase is ‘look for the down-side’. The third phase is ‘how do we make money out of this?’ Just three months after the survey was published, the largest sell-side firms are now starting to move.
The issues facing them are considerable, but so are the opportunities. MiFID removes the pseudo-monopolies of exchanges across the EU, allowing sell-side firms to offer their own trading platforms to investors in direct competition to exchanges. The exchanges themselves are less and less member co-operatives as they have increasingly IPO’d and are listed companies on their own exchanges. Around 20 sell-side firms account for more than 70 per cent of the equity order flow across the EU. If they start to retain more of that order flow for execution on their own trading platforms, rather than routing it to the exchanges, this new competition in the market will have a major impact on the EU’s financial services infrastructure.
A change of this size can affect the whole perception of financial markets. One challenge will be how the financial information industry will create transparency in this new pan-EU market. Liquidity in one instrument may no longer be tied to one single execution venue, such as an exchange, but may be spread across multiple venues. Making all of those venues equally transparent is a huge task of data collection and consolidation – a task that continues right down to providing a consolidated view of the market at the desks in buy-side firms.
The market, and the success of MiFID itself, will be very dependent on the plans of the data vendors and the exchanges to gather, consolidate and re-distribute all of this data. As yet there are no clear signs that the data vendors are ready to take on this load. One large data vendor has said, “My customers aren’t asking my salespeople for solutions to their MiFID problems, so they must not have a MiFID problem”.
The market is now waiting for the draft level 2 text of MiFID to be issued by the European Commission. This in itself is not a straightforward issue, as every aspect has to be negotiated across the EU first. Originally due to be out in December 2005, the level 2 draft was delayed till early January 2006, and has now been delayed again. Investment firms have been saying that the details of MiFID are not clear yet. The expectation is that the level 2 draft will provide them with the detail that they need to start moving ahead with MiFID plans and projects.
Today it feels like the market is gathering its breath waiting for the level 2 draft so that it can set off on the route to implementation and compliance. There are only 21 months left till MiFID comes into force. And by then the European Commission will already be looking at how it may pay more attention to the structures of the fixed income and derivatives markets.