Impact of MiFID on Stock Exchanges
The Markets in Financial Instruments Directive (MiFID, see box at end) contains 73 articles and will affect exchanges, banks, pension and other asset managers, investment service providers and issuers. The following articles of the Directive will affect the business model of a stock exchange.
| Article | Area |
|---|---|
| 21 | Best execution |
| 22 | Client order handling quotes |
| 27 | Firm public quotes |
| 29, 44 | Pre-trade transparency |
| 28, 30, 45 | Post-trade transparency |
One of the most important features of MiFID is that it recognizes and formalizes the regulation of multilateral trading facilities (MTFs), such as electronic communication networks (ECNs) and automated trading systems (ATSs). One of the major consequences of MiFID will be changes in the role and operation of stock exchanges. MiFID circumvents the concentration rule, allowing proper cross-border trading via MTFs. It also treats some broker-dealers that currently cross trade internally on a systematic basis as regulated markets (systematic internalizers – SIs). During trading hours, the SIs will be required to publish firm public quotes in shares that they deal in and that are quoted on a regulated market. In effect, they will be acting as mini stock exchanges. This is because the transparency rules suggest that pre-trade firm quotes have to be made public on a reasonable commercial basis and that post-trade reporting of the volume, price and time of a trade has to be done as close to real time as possible.
The MiFID working group made an announcement that the EU commission is expecting 400 SIs (meaning new exchanges). Even if that number is debatable, the competitive landscape for exchanges will change with the implementation of MiFID. The existing stock exchanges have an uphill task in their hands, not only because of the birth of new exchanges, but also due to the advocated changes in the fundamentals of conducting business.
A stock exchange acts at two levels: as a primary market and as a secondary market. As a primary market, a stock exchange liaises with investment banks and businesses that are looking to raise capital by selling shares. Much of a stock exchange’s work, however, is as a secondary market, providing a platform by facilitating transactions in various financial instruments.
At present, the primary exchanges in Europe work with ‘concentration rules’ in place in various European countries. Under these concentration rules, investment firms are generally required to send client orders for listed equities exclusively to primary exchanges.
Concentration rules are in place in France, Italy and Spain. In these markets, most orders must be sent to the national exchange. These are the markets that would experience the greatest change under MiFID. In Germany and the UK, all orders are not required to be sent to a national exchange, but in the UK, all members of the London Stock Exchange (LSE) are required to report trades involving issues listed on the LSE. Also, members of the LSE must pay the LSE for this trade reporting. Because the LSE enjoys a majority share of the market, it can be safely said that a virtual concentration rule exists.
Currently, across Europe, investment firms are generally required to report their off-exchange trades to their national exchanges. The national exchanges charge trading fees for this and then sell the market data to market participants, either through data consolidators or through direct feeds.
While acting as the secondary market for securities, stock exchanges earn their revenues from different sources, such as:
Exchanges typically charge fees to the firms that wish to be listed. This fee has two components: initial fees and, subsequently, annual fees. For many exchanges, the listing fees account for a major portion of their revenues. The primary drivers for this revenue stream are:
Competition from electronic exchanges, heightened mergers and acquisitions (M&A) activity, and strict listing requirements can lead to a fall in the number of companies listed on an exchange. As pointed out earlier, MiFID takes into account alternative avenues, thus heightening the competition for fresh listings and retaining the existing listings.
With companies looking to reduce costs and gain access to increased liquidity in the new electronic market environment, company listings could also move more easily between exchanges. So, in the post-MiFID scenario, exchanges need to do something extra to attract this revenue stream.
The growth in the number of market devices is used as a proxy for growth in revenue by the data processing revenue segment. The stream is dependent on the extent of usage of floor-based trading and electronic trading in the exchange. As MiFID would force the exchanges to adapt to electronic trading in search of best execution, this revenue stream is expected to decline in the future.
Market information (data) fee amounts to the revenue that the exchanges earn from providing historical and statistical data to subscribers. While the number of market data devices is a primary driver for this revenue stream, the overriding driver is the volume traded. Some two or three years ago, this stream accounted for 40% of LSE’s revenue.
MiFID allows investment firms to publish their post-trade data for equities trading through a vastly expanded set of channels. Currently, investment firms are required to report their off-exchange trades to their national exchanges. The national exchanges charge trading fees for this, and then sell the market data to market participants, either through data consolidators or through direct feeds. Once MiFID is implemented, these flows of data/information and cash will be either eliminated or possibly reversed.
In the post-MiFID scenario, investment firms will no longer be willing to report their off-exchange trade data to the exchanges and pay for the privilege of doing so. Rather, investment firms will demand a share of the revenues generated by their trade data. Given the freedom to report their trades through any exchange or MTF, the competition among exchanges and MTFs in order to attract these trade reports would increase.
In this market data space, stock exchanges would face legal and regulatory battles over intellectual property inherent within the price and quote data arising from their trading systems.
The average daily volume can be used as a proxy driver of this revenue stream. Due to the possible decline in new listings and possible market fragmentations because of new trading avenues, it is expected that the exchanges would lose some revenue from this source. This hypothesis gets some relief from the requirements for best execution, which the stipulated exchange might not provide all the time.
Exchanges have traditionally performed important roles as regulators – making and enforcing rules for a range of market activities. Their core areas of regulation relate to members/participants, the products admitted to trading and the trading itself. Some exchanges also have regulatory or quasi-regulatory functions in respect of a number of other market services, including clearing and settlement. An exchange has a specific role in providing a general regulatory oversight of member firms and those firms pay a specified fee for that service. But now, with so many independent alternative avenues with their own technological capabilities to trade and publish trade data, the exchanges might decline to act as the authority to verify the sanctity of the data published and OTC products traded. The regulatory revenues are also driven primarily by the increase in member firms’ gross revenue so the impact of MiFID on this source of revenue remains unclear.
With all major changes in the market, the MTFs and SIs will need to invest in IT systems and upgrade their trading platforms. Stock exchanges with their own trading platforms can leverage their technology and experience to generate additional income by addressing this demand. So we can expect significant revenues from this avenue for the exchanges that have superior technologies. Exchanges such as Euronext and Xetra, who are in a position to adapt, can sell their order-matching systems to investment firms wishing to internalize and to MTFs.
This revenue stream is dependent on the specific investments that the exchange has made so MiFID will have almost no impact on this.
With stiff competition looming large, the exchanges need to createvalue by driving depth and breadth in the markets through various initiatives.
These are the panacea for the exchanges. The exchanges need to provide the clients with a global or at least a pan-European service for most liquid stocks or blue chips under a single rule book supporting multiple currencies
In this transitional turmoil, exchanges should be open to partnerships and M&As with suitable candidates to expand beyond their borders to stay competitive and generate new revenue sources. Exchanges should vouch for the creation of something similar to national best bid and offer (NBBO) or European best bid and offer (EBBO) type business model. MiFID doesn’t speak of the creation of any national or European best bid and offer. The existing national stock exchanges would create something similar to the best bid and offer that had been introduced in the US to act as a reference point for all trading venues. This can be a win-win proposition for the exchanges.
Exchanges need to focus on the new generation of derivatives and high-earning innovative trading products that will provide investors even greater flexibility and new investment opportunities. The exchanges should offer the users more choice in post-trade services. Exchanges can look at having independent clearing and settlement systems, which are often used as cash cows to support exchange dealings.
National stock exchanges can offer a regulatory toolkit for MTFs and ECNs, which can include:
Exchanges may need to be flexible and innovative even on the pricing front and can try changes such as the following:
The exchanges can leverage their capabilities by taking on the opportunities that arise from the numerous investment firms seeking new channels to meet their transaction reporting obligations. With sanity of data reported as a big issue, the exchanges can take up the role as the verifying authority. There is a clear role for exchanges to seek opportunities to grow their services and become primary data consolidators and vendors for their markets.
MiFID removes pseudo-monopolies of exchanges across the EU but the extent to which it will affect exchanges will depend on the following factors:
On a case-to-case basis, exchanges can choose to combine the approaches to combat the MiFID storm. Armed with clear objectives, efficient business and technology architecture plans, and properly channelled budget and human resources, exchanges would be able to minimize the negative effect of MiFID.
MiFID was adopted by the European Parliament and European Council on 21 April 2004. The objective of MiFID is to create a set of common regulations for financial services firms in Europe, which will in turn drive the creation of a single pan-European market, following implementation of the euro. The deadline for MiFID implementation is November 2007 and its focus is enhanced investor protection and greater market transparency.
MiFID advocates high-level organizational and business conduct standards that apply to all investment firms. These include new standards for managing conflicts of interest, best execution, customer classification and suitability requirements for customers. MiFID also sets standards for regulated markets (exchanges) and MTFs, and sets out pre- and post-trade price transparency requirements for equity trading. It also removes local concentration rules and sets to provide a more level playing field for services provided by regulated markets and MTFs.