Looking for clarity

The European Union's Markets in Financial Instruments Directive is set for implementation in April 2007. But there's plenty of confusion as to what the new regulations will entail – particularly with regards to 'best execution'. By Hann Ho

With the April 2007 deadline for implementation of the European Union's Markets in Financial Instruments Directive (MiFID) looming, alarm bells have begun to ring in the investment banking world. Of particular interest for many financial institutions are the consequences of putting in place the principles of 'best execution'. The obligation to provide investors with the best available price and to publish pre- and post-trade information will be difficult enough for the cash equities market, currently the only asset class covered by the directive. But if the rules are extended to bonds and derivatives – as is suggested in the directive – the requirements will entail a major shake-up of banks' systems, policies and use of data.

Despite the potential impact to the banking industry, MiFID has not featured highly on banks' agendas, with resources focused instead on meeting the demands of Basel II, Sarbanes-Oxley and International Financial Reporting Standards. But with the latest consultation period under way, aimed at clarifying the finer details of how the directive's 73 articles will be implemented (the so-called 'level 2' of MiFID), compliance and trading units have been forced to speed up their assessments of how the new directive will affect their trading activities.

MiFID's scope is wide-ranging and will allow financial institutions more freedom to operate within the EU. The objective is to create a more transparent, single market for financial instruments, superseding the existing Investment Services Directive's 'passporting' arrangements, which allows financial institutions to operate in other member states.

However, the proposals require banks to upgrade systems and implement new pricing and trading platforms, leading to huge costs for financial institutions. One of the most contentious proposals is Article 21, which states that investment firms have the "obligation to execute orders on terms most favourable to the client... when taking into account price, costs, speed, likelihood of execution and settlement, size, nature, or any other consideration relevant to the execution of the order".

To achieve this, investment firms will be required to monitor the effectiveness of the order execution arrangements and "must be able to demonstrate to their clients, at their request, that they have executed their orders in accordance with their execution policy". In other words, the best execution obligation means dealers and brokers will have to implement a trading process that can minimise the cost of trading and can prove the investors' interests have been put first. That, in turn, means that banks will have to have real-time access to a wide array of pricing venues.

Philip Hindley, senior manager at Ernst & Young's financial services regulatory practice in London, says in the past, best-execution controls have been achieved through procedural controls (that is, adequate data management systems that support a certain policy) rather than by monitoring the market, and suggests that this will also be the case with MiFID. Regulators will actually find it difficult to prove that investment firms did not achieve best execution, but Hindley adds the procedural element of Article 21 could trip investment firms up. Under MiFID, firms are required to establish an order execution policy and monitor the effectiveness of that policy. Regulators can easily ask banks if they have a reasonable best execution policy in place and whether customers have seen and agreed to it.

However, some market participants believe these steps will help end-users by providing greater transparency on pricing. René Karsenti, the director-general of finance at the European Investment Bank (EIB), the financing arm of the European Union in Luxembourg, asserts that the broad sweep of the directive is positive and should result in a more efficient euro-denominated bond market – should MiFID be extended to bonds.

"We're interested in an efficient market in terms of price or trade transparency, but also in terms of cost for us as users of the market," he says, dismissing complaints over the cost of implementation as over-simplistic. "Investment banks are probably trying to find the right balance between supervision and what they can deliver. If they can organise and regulate themselves, and provide the minimum level of transparency that market participants are entitled to, we can avoid imposing additional layers of regulation."

But it is not only the best execution requirements that are controversial. Among others, there are provisions to oblige firms to "uphold the integrity of markets, report transactions and maintain records" (Article 25), to make "make public firm quotes" (Article 27) and to publicly disclose details of trades executed (Article 28). It means banks will have to publish trade information as close to real time as possible, and make all transaction data available for two weeks after the trade. This also includes internal trades. In other words, if a bank is able to achieve best execution via an internalised order, the bank will have to publish its quotes and prices.

The finer points of these articles, like the best execution proposals, are the subject of a furious debate between the European Commission and market participants. "A good balance should be found between some kind of transparency and efficiency of over-the-counter products, which provide a lot of flexibility for users," says the EIB's Karsenti.

The directive appears to be similar in scope to the US National Market System (NMS), which was pushed through the Securities and Exchange Commission (SEC) in April. Similar to MiFID's best execution and transparency requirements, the US securities markets will also be subject to transparency rules that aim to force brokers and exchanges to guarantee investors the best available price. A market centre must "establish, maintain and enforce policies and procedures reasonably designed to prevent trade-throughs – the execution of an order in its market at a price that is inferior to a price displayed in another market". Similar to its European counterpart, banks will have to put in place more sophisticated systems to ensure best execution principles are adhered to. It is due to be implemented in July 2006 and, like the European proposals, is ruffling a few feathers.

In the NMS open meeting, SEC commissioner Cynthia Glassman raised strong objections to the potential costs of meeting all of the requirements. "The cost savings to investors from the rule is estimated at a mere $321 million. Given that the dollar value of trading on both Nasdaq and the New York Stock Exchange totalled $18.7 trillion in 2003, with the dollar value of market and marketable limit order trading totalling $11.9 trillion, $321 million is only a rounding error. As a per cent of the total dollar value of trading, the $321 million benefit is less than one hundredth of 1 per cent," she said.

Similar concerns are being expressed over the MiFID proposals. The cost of implementing systems to comply with the directive will be around €8 million–9 billion for each large investment bank, says one London-based consultant.

But the problems don't stop there. The European Commission is debating whether to extend the directive's reach to include asset classes other than cash equities. The financial instruments listed in the directive that could fall under its purview include futures, options, swaps, forward rate agreements and "any other derivatives contracts relating to securities, currencies, interest rates or yields, or other derivatives instruments, financial indexes or financial measures that may be settled physically or in cash".

If banks think that achieving best execution for cash equities is difficult, applying it to the derivatives markets will be even more of a problem. "If you read the directive, it's plainly written from the point of view of equities and possibly bonds. But it's far less clear how the directive will apply to other OTC instruments," says Hindley of Ernst & Young.

Putting aside the fact that there are no liquid, observable market prices for some derivatives products, prices can depend on a variety of factors. For instance, if the bank has an axe it may be able to quote aggressively for a particular derivatives product, making it difficult for competitors to match that price. Other firms may charge more for taking illiquid risk onto their books.

It is unclear just how far MiFID will apply to the bond and derivatives markets. But with uncertainty over the future scope of the directive, the UK's Financial Services Authority (FSA) published a discussion paper on September 5, questioning whether further transparency is required in the secondary bond market. Hector Sants, the FSA's managing director for wholesale business, says the FSA is seeking answers to the fundamental question of "whether there are any possible market failures caused by the lack of transparency in the UK and EU bond markets. We will be seeking views on the practicalities of any regulatory change in this area".

The FSA points out that the benefits of MiFID are as yet unclear, while billions of euros will have to be spent to put in place the necessary systems to allow financial institutions to comply with the directive. "It is deeply unsatisfactory that UK financial services firms face major changes, with the associated costs, for an initiative which has been subject to no comprehensive EU cost-benefit analysis to assess the specific contribution it might make to unlocking the prize of a more integrated European capital market. That kind of approach to policy-making cannot be sensible," said Callum McCarthy, FSA chairman, addressing the regulator's annual public meeting on July 21. On the directive itself, McCarthy has expressed doubts: "It is far from clear that the benefits to the UK will outweigh the costs."

Martin Pluves, a financial services consultant at PA Consulting Group in London, says the directive was designed for retail end-users in Europe, and adds that supervisors cannot easily take principals from one market and apply to them to another. "There is genuine concern in the industry over the way in which MiFID will manage the dichotomy between wholesale and retail businesses. Regulating both markets under a single directive presents many challenges. The concern is that one or other may be dissadvantaged," he explains. "The intentions of MiFID to protect retail investors are clear, but there are question marks over professional investors and whether they feel the addition protection justifies the likely increase in costs and resulting impact on spreads."

Ultimate winners

Ian Berriman, a financial systems specialist at PA, adds that the ultimate winners will be those who already have electronic capability. "The winners will be those who are highly electronic in the way they conduct their business. Best execution policies act as a catalyst for improved automation and efficiency in the front office. MiFID could make it difficult for those organisations with less developed electronic capability to demonstrate they adhere to a best execution policy," he says.

But cost – the most oft-repeated complaint about systems – is not the only issue. "Another reason why people are grumpy is the time element. The implementation for April 2007," says one senior compliance officer at a major investment bank. "We have the choice of either starting working now on a moving target – which is very impractical – or waiting until the end of 2006 when all the results of the consultation on implementation are known. But this isn't a real choice because this won't leave us the time to implement. The implementation timetable of April 2007 is already a one-year extension over the previous deadline and it is unlikely the Commission will want to give another extension," he says.

The compliance officer also feels that liquidity may suffer in particular markets. "The first-order consequence of MiFID is simply the cost of installing and maintaining the new computer systems," he explains. "The second-order consequence is that it may change the dynamic of the markets. These proposals were designed for the retail market, to enable them to compare prices. But this is the general problem with the EU as there is a large retail/wholesale dichotomy. France and Italy are much more retail-driven markets, while the UK is much more wholesale-driven. These proposals could stifle innovation in the wholesale market."

The MiFID articles

The European Union's Markets in Financial Instruments Directive comes into effect in April 2007 and has a total of 73 articles, each outlining specific proposals with the aim of creating a single financial market. Investment banks are currently lobbying the European Commission over the final details of the implementation of the directive. Some of the major articles include:

• Article 21 obliges firms to practise best execution in transactions with clients. It says: "Member states shall require that investment firms take all reasonable steps to obtain, when executing orders, the best possible result for their clients taking into account price, costs, speed, likelihood of execution and settlement, size, nature or any other consideration relevant to the execution of the order." It goes on: "The order execution policy shall include, in respect of each class of instruments, information on the different venues where the investment firm executes its client orders and the factors affecting the choice of execution venue", while "member states shall require that investment firms provide appropriate information to their clients on their order execution policy".

• Article 22 relates to client order handling rules. "Member states shall require that investment firms authorised to execute orders on behalf of clients implement procedures and arrangements which provide for the prompt, fair and expeditious execution of client orders, relative to other client orders or the trading interests of the investment firm."

• Article 27 requires investment firms to make public firm quotes. "Member states shall require systematic internalisers in shares to publish a firm quote in those shares admitted to trading on a regulated market for which they are systematic internalisers and for which there is a liquid market. In the case of shares for which there is not a liquid market, systematic internalisers shall disclose quotes to their clients on request. The provisions of this Article shall be applicable to systematic internalisers that only deal in sizes above standard market size. Those that deal in sizes above standard market size shall not be subject to the provisions of this Article."

• Article 28 covers post-trade disclosure by investment firms, instructing member states that they "shall, at least, require investment firms which, either on own account or on behalf of clients… to make public the volume and price of those transactions and the time at which they were concluded. This information shall be made public as close to real time as possible, on a real commercial basis, and in a manner which is easily accessible to other market participants".

• Article 29 stipulates the pre-trade requirements for multilateral trading facilities (MTFs). Investment firms and market operators operating an MTF are required to "make public current bid and offer prices which are advertised through their systems in respect of share admitted to trading on a regulated market… Competent authorities shall be able to waive the obligation in respect of transactions that are large in scale compared with normal market size for the share or type of share in question".

• Annex 1, section C lists what it considers to be defined as financial instruments. The directive will initially apply to equities only, but the European Commission is obliged to decide by the time of implementation in April 2007 whether to extend its remit to other asset classes, including bonds and derivatives.

Other than securities, money-market instruments and units in collective investment undertakings, the list includes options, futures, swaps, forward rate agreements and any other derivatives contracts relating to securities, currencies, interest rates or yields. This includes cash and physically settled commodities, credit derivatives, weather, freight, emissions, inflation rates or "other official economic statistics that must be settled in cash or maybe settled in cash at the option of one of the parties, as well as any other derivative contracts relating to assets, rights, obligations, indexes and measures not otherwise mentioned in this section, which have the characteristics of other derivative financial instruments".