A Point of View
The Impact of MiFID II Regulation on Trading Venues The MiFID II regulation was adopted by the European Union (EU) in May 2014 and the implementation deadline for all market participants is January 2017. In this article, we outline the key directives of this regulation and discuss the impact it will have on trading venues across the EU. We discuss how this new regulation will impact the business operations of capital market firms, and what changes they will need to introduce in their IT landscape to ensure adequate readiness when the regulation comes into force.
Introduction In May 2014, the European Union (EU) council adopted the Markets in Financial Instruments Directive II (MiFID II), which serves as an update to the MIFID I guidelines, and also introduces new directives for regulation of non-equity financial instruments. The original MiFID guidelines released in 2004 introduced alternate trading venues — Multilateral Trading Facilities (MTFs), and improved measures for transparency and investor protection in equity trading. Now, MiFID II is looking to replicate this for other asset classes with a prime focus on Over-The-Counter (OTC) derivatives that are currently traded outside of regular market venues. This is expected to have far-reaching effects on the EU trading landscape, similar to what MiFID I had when it came into effect in 2007. With MiFID I, the MTFs took on the monopoly of regular stock exchanges across the EU, thereby increasing competition and market efficiency, leading to significantly reduced trading costs for investors. However, it also brought about unintended consequences like dark pool trading, market fragmentation, and related challenges. Therefore, it is prudent to wait until 2017 to evaluate the implications of this 'sequel'. The main objective of the MiFID II framework is to further the integration, competitiveness, and efficiency of the EU financial market. A key prerequisite to achieve this objective is to regulate the OTC derivatives markets by enabling electronic trading as was agreed by the G20 leaders at the G20 Summit in September 2009, at Pittsburgh. Along with MiFID II, the EU has also introduced the Markets in Financial Instruments Regulation (MiFIR) to ensure the key directives become mandatory regulations across the constituent countries, and to eliminate any country specific adaptations. Figure 1 depicts the associated timelines for MiFID II and MiFIR regulations. All entities are expected to implement the required changes by January 3, 2017.
MiFID II and MiFIR Timelines Apr-May 2014
Adopted by the EU parliament and council
July 2014
Dec 2015
Regulation becomes effective in EU
Level 2 text release by ESMA
Figure 1: Timelines for MiFID II and MiFIR Regulations
3-Jan 2017 Final Implementation deadline
We studied the MiFID II regulation and arrived at some key directives and their probable impact (see Table 1). MiFID II Directive
Key Areas
Market infrastructure
Instruments
n n
n
n n
Algorithmic and High Frequency Trading
Introduction of Organised Trading Facility (OTF) Multilateral Trading Facilities (MTF) platform for SME markets
MiFID II to: n Extend equity coverage to ETF, depository receipts, and certificates n Mandate OTC derivatives to be traded on exchange n Cover commodities and emissions as well n
Reporting
Impact
n
Pre-transparency for equity to cover all trading venue Pre and Post transparency for bonds, OTC, commodities, and emissions Trade reporting through consolidated tape providers Transaction reporting to be done by investment firms and venues for all asset classes
n
n
n
n
n
n
n
n
Safeguards for algorithmic and High Frequency Trading (HFT)
n
n
Governance
n
HHeightened powers over derivatives position management
n
n
OTF to cover trading of non-equity asset class outside of current RM and MTF Operation of separate MTF for SME listing and trading to aid their growt Market participants to comply with MiFID for extended asset classes Eligible OTC derivatives need to be traded on exchanges (RM, MTF, and OTF) and cleared through central counterparty Bid and Ask details to be provided by all venues covering all asset classes for pre-transparency All execution details to be provided in near real-time to public and regulator for post-transparency Reliable, timely market data consolidated across the EU to be made available, initially for equity instruments and later for non-equity instruments All entities involved in HFT to come under MiFID purview Venues allowing HFT to ensure controls are in place to handle disorderly trading Weekly reporting to be done, and limited number of positions a participant can take on commodities Can enforce a participant to reduce the positions when needed Done to ensure liquidity, prevent market abuse, and orderly functioning
Table 1: MiFID II – Key Directives and Impact Areas (Source: TCS Internal)
Impact on Trading Venues MiFID II introduces a new alternate trading venue called Organised Trading Facilities (OTF), similar to the introduction of MTFs by MiFID I. OTFs are venues operated by an investment bank, or a market operator that brings in multiple third-party buying and selling interests in financial instruments as per pre-determined rules, to result in a contract. OTFs are expected to cover OTC derivatives as well as other organised trading occurring outside of current Regular Markets (RM), Multilateral Trading Facilities (MTF), and Systematic Internalisers (SIs). OTF is essentially EU's version of Swap Execution Facility (SEF) — the offshoot of the United States' Dodd-Frank Wall Street Reform and Consumer Protection Act — though it covers instruments other than swaps as well. The major difference between OTFs and other trading venues (RMs, MTFs, and SIs) is the element of discretion allowed to participants in case of access as well as in terms of transaction execution itself for OTF operators. This means that in case of RMs, MTFs, and SIs, all transactions will be executed as per pre-determined rules. On the other hand, OTF operators have a degree of discretion while allowing participants to access their platform and also while executing transactions, without compromising best possible execution capabilities. While OTFs are allowed to exercise discretion in their operations in specific circumstances, they are not allowed to do principal trading using their own capital, with the exception of highly illiquid fixed income instruments like sovereign debt, on a special, case-to-case basis.
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Table 2 gives a comparison of alternate trading venues from the perspective of various parameters. Category
SI
Geographies covered
EU
Asset class
Equities, bonds, all eligible OTC derivatives, commodities, and emission allowances
Pre-trade transparency
Specific requirements
MTF
OTF EU
Equities, bonds, all eligible OTC derivatives, commodities, and emission allowances
Bonds, all eligible OTC derivatives, commodities, and emission allowances
Required
Post-trade transparency
SEF US Interest rate swaps, credit default swaps Transparency to be promoted
Required
Transaction execution
Non-discretionary
Non-discretionary
Discretionary
Non-discretionary
Venue access
Only for their clients
Non-discretionary
Discretionary
Non-discretionary
Proprietary trading
Only proprietary trading
Not allowed
Highly restricted
Not allowed
Clearing
Central clearing
Central clearing
Central clearing
Central clearing
Execution
Electronic
Electronic
Electronic, voice, and hybrid
Electronic
Table 2: Comparative Snapshot of Trading Venues – SI, MTF, OTF, and SEF (Source: TCS Internal) Aligning with the G20 agreement, all eligible OTC derivatives have to be traded on electronic exchanges, cleared through the Central Counter Parties (CCP), and be compliant with regulatory transaction reporting requirements. The EU council expects all standardised OTC trades with sufficient liquidity to move to organised trading venues (RM, MTF, and OTF) with the exception of some large deals. The European Securities and Markets Authority (ESMA) is responsible for identifying eligible OTC products to be traded on the EU exchanges, unlike in the US where the SEF decides based on the annual review of instrument liquidity. Instruments covered would be bonds, swaps, emission allowances and commodities, and their derivatives. Moving OTC derivatives to electronic exchanges like OTF would impact banks more than the trading venues. Currently, investment banks benefit from the bilateral trading of OTC derivatives by picking up the difference in the buying and selling rate. Now, as most of these instruments move to regulated multilateral exchanges, banks would have to move toward fee-based models similar to what is being done for equities and other exchange traded instruments. This will have a significant impact on their revenues. On the other hand, the investor community would be the biggest beneficiary, as OTC instruments get regulated better, thereby reducing the high risk associated with them. However, a more important effect would be the cost elements coming down with better and more sophisticated infrastructure being provided by alternate venues, the way MiFID I did for equity instruments. The introduction of an additional trading venue, apart from RM and MTF, will result in more fragmented trading. This will increase the complexity in collecting and disseminating market data for the regulators. Restriction of proprietary trading could also impact liquidity for some OTC derivatives and this could pose challenges too. MiFID II will also extend the scope of Systematic Internalisers (SIs). SIs as trading venues were introduced in 2007 by MiFID I. These are single dealer trading venues operated by investment banks that can execute client orders against their own books. They cannot bring in multiple buying and selling parties like other multilateral trading venues. Pre and post-trade transparency rules are applicable to them in specific cases. The key point here is that banks can be SIs for particular instruments at the International Securities Identification Number (ISIN) level only, and not for the entire asset class. As per MiFID II, SIs that are now dealing with equity instruments are allowed to deal with bonds, OTC derivatives, commodities, and emissions.
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Impact on Venues due to Transparency Measures Currently, pre and post-trade transparencies are applicable only to equities traded on RMs. With the implementation of MiFID II, this would extend to alternate trading venues (MTFs), equities, and include equity-like instruments such as Exchange Traded Funds (ETFs), depositary receipts, and certificates. MiFID II also mandates pre and post-trade transparencies for all other non-equity asset classes, and across all trading venues (RM, MTF and OTF) similar to equities. On pre-trade transparency, trading venues need to ensure bid and ask details to be made available for all instruments, with the exception of instruments that have low liquidity. On post-trade transparency, details of executed transactions are to be reported for public consumption on a near real-time basis for liquid instruments, with delays allowed for instruments with liquidity challenges. OTC trading operates on Request for Quote (RFQ) basis, unlike order book-based equity trading. One of the main challenges with respect to having pre-trade transparency requirement for OTC derivatives that function mostly on RFQ, is the impact on the pricing discovery process. Based on pre-trade transparency details available, other participants can impact price movements adversely, and hence affect liquidity as well. This is the reason the Dodd-Frank-Act in the US does not mandate pre-trade transparency for swaps traded on SEF, but only promotes it.
Conclusion Introduction of the MiFID II is expected to have notable effects on trading platforms for non-equities asset classes. Introduction of OTF and MTF for SMEs means alternate trading venues in addition to existing RMs, MTFs, and SIs competing with each other for market share. This will result in further fragmentation of the market, but will offer more choices and better infrastructure to investors. Moving OTC trading to organised venues promises to boost investor transparency and protection by eliminating the opacity associated with OTC trading, and consequently bring down systemic risk. Additionally, stringent regulatory monitoring is also expected to push trading venues to upgrade their platforms for strengthening market surveillance and monitoring activities. This will result in additional burden on market venue operators, but will mean improved protection measures for investors.
About the Author Thirumalai Vasan Sivaramakrishnan Thirumalai Vasan Sivaramakrishnan is a Domain Consultant with the Capital Markets practice of the Banking and Financial Services (BFS) business unit at Tata Consultancy Services (TCS). He has around 17 years of experience in the IT industry, with capital markets being the core area. Sivaramakrishnan has worked on strategic consulting engagements for a host of global investment banking organisations, and has deep expertise in post-trade back office platforms and the entire trade life cycle. He is currently involved in pre-sales support and conceptualisation and development of new offerings for the capital markets space.
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