MiFID2: Filling in the Gaps
Regulation has become synonymous with the 2008 financial crises. Most initiatives have been linked to causes that triggered it. But regulation, like any other business, has to keep up with changing market conditions and technology, with regular updates and, at times, an overhaul. MiFID2 (Markets in Financial Instruments Directive) was announced by European regulators in 2011. It still has to be drafted into technical standards and enacted as rules by the individual countries. This article highlights the key changes and presents a view on the need for an updated MiFID2.
In trading markets there are two big categories of players: investors and speculators. Any healthy market requires both these types of players to function well and have sufficient liquidity (so that participants can easily enter or exit a traded position). Investors trade to grow savings, hedge business risks, etc., and have a long-term outlook. Speculators look for a quick return and have a somewhat short-term outlook. They also provide liquidity. Regulators enact rules that are fair to all types of participants but in an area of conflict will favor the investor. Some examples of these situations are arbitrage related and high-frequency trading.
MIFID2 brings a set of changes, some of them harmonized with what is already covered by EMIR (European Market Infrastructure Regulation) and others to keep regulation in tune with the times. There is a strong focus on investor protection. Changes can be classified in two categories: trading/marketplace and investment.
The trading markets
The pre-trade/post-trade transparency has expanded to all asset classes and different trading venues. Earlier this was more for listed instruments like equities and derivatives. The reporting of trades of all asset classes and by all venues, including market makers and service integrators, is a mandate that includes OTC, commodities, and emission trades. They have to be reported post-trade within a time frame. Algorithms and HFT (high-frequency-trading) systems should be monitored and managed with policies and frameworks to prevent erroneous trades. Access to venues and clearing houses has to be non-discriminatory for brokers and clients. MIFID2 covers OTF (organized trading facility) the new marketplace for OTC instruments, with operational guidelines like transparency rules, crossing client orders with OTF’s capital, discretionary execution of orders, etc. Firms that are equity market-makers and have crossing systems (internal matching) will be treated like an MTF (multilateral trading facility) and regulated appropriately. Voice trades need to be recorded and stored. Position limits of commodity derivative trades have to be monitored by trading venues and ensured that they are within prescribed limits. This is being done to prevent market abuse.
Better price transparency will ensure clients get better prices with guidelines for all asset classes on publishing post-trade prices and pre-trade orders. New articles have documented requiring organizations to have policy/processes/frameworks to ensure that the trading systems are stable. New trading products being introduced could be evaluated by regulators to ensure that they are safe for investors and they are being targeted to the right audience. Brokers need to ensure that client trades are getting the best trade price, where the price includes the commission costs. This is to ensure that there is no conflict of interest in routing client orders to different venues. Many MiFID2 rules will apply to third-country firms providing services to clients in the member states, ensuring protection even when trading in non-EU venues.
Technology keeps changing with time: Technology solutions that were expensive a few years back could become mainstream. The amount of data being generated has increased dramatically, but technology's ability to process large amounts of data has also improved. Today there are different flavours of Hadoop with the ability to process streaming and large datasets quickly and at a low cost. The data networks (microwave-based and co-location) and processing power have improved, making HFT trading more sophisticated. Low-latency trading that is computer driven can lead to bad trades and huge losses to the trader and instability in the market, affecting everybody. Access to more data (through new reporting requirements) and better technology capabilities enables regulators to mine for patterns in trades in a faster and cheaper way -- like different scenarios of market abuse, concentration of risk in an asset class or counterparty, etc.
There has been some confusion between EMIR and MiFID2. EMIR launched a couple of years earlier to meet an immediate regulator requirement in OTC trading and reporting and in aspects of investor protection. It is a law that all member EU states have to adopt. MiFID2 expands on the EMIR mandates. Being a directive, it has to be converted to technical standards and drafted into national law by member states.
Regulations have to keep up with changing conditions in the marketplace. In many areas, the US has already passed new rules and regulations. MIFID2, though a bit late and delayed, appears to be fairly comprehensive and in tune with the times. Once enacted by the member states, this could dramatically alter the financial landscape, making the business of finance more predictable and consistent for market participants and safer for investors.Senthil Radhakrishnan has 16 years of experience in Investment Banking IT, including experience covering various instruments such as Equities, Listed Derivatives and Rates in Middle/Back-office and in Enterprise Risk. He is currently VP for Capital Market Solutions Practice ... View Full Bio