MIFID II/MIFIR – EVOLUTION OR DISRUPTION OF CURRENT BUSINESS PRACTICE?
How disruptive is the MiFID Review for the professional life of a European banker? Which workflows will stay roughly the same and which ones will change beyond recognition? Silvano Stagni, global head of research at IT consultancy, Hatstand investigates.
MiFID II/MiFIR are supposed to change the way financial instruments are traded creating a more transparent environment, a measurable execution quality, a structured playing field for all financial instruments and better protection for investors. The way people work will have to change to achieve this. Matters are further complicated by interaction with other sets of regulations such as Market Abuse or the forthcoming ‘European Long Term Investment Funds’ Directive.
What are the changes and how significant are they? The extension of scope to non-equity products means clients will be classified by asset class; this is a significant structural change. It is no longer a drop-down list with classification purely associated with the client but a matrix with the classification associated with client and asset class. From the perspective of a client onboarding workflow, the basic ‘Know Your Client’ steps will not change. The implementation of those steps will change because the data structure behind it will have to be modified to accommodate the fact that ‘Client Type’ is now tied to two entities: Client and Asset Class and not just one – the Client.
Business units that execute non-dark trades in cash equity will see some changes brought about by stricter definitions of best execution, execution quality reports (introduced by MiFID II/MiFIR) and the way orders are managed. The latter is mostly due to the disappearance of the ‘execute or cancel’ order (also known as ‘do or die’) since cancelled orders will have to stay in the order book for one reporting cycle. A different scenario awaits operators of dark pools since it will only be possible to execute trades without affecting market price (the basic concept behind ‘dark trading’) within the remits of two specific pre-transparency waivers (negotiated trades and large in scale trades).
Since pre- and post-trade transparency are the domains of a trading venue, dark trading can only take place within this environment. Financial institutions that currently operate dark pools will have the choice of registering as a MTF (Multilateral Trading Facility) or SI (Systematic Internaliser), of using third-party platforms, or leave the business altogether. In any case this will be a drastic disruptive change from the way dark pools are presently organised and each decision will affect the cost/revenue model of the unit, if not the institution.
The extension of best execution to non-equity will impact many aspects including client management, order management and execution. The biggest change will result from the obligation to trade liquid instruments on exchange. There will no longer be any choice as to whether to trade an instrument OTC or on exchange. This depends on the definition of liquidity for specific asset classes but if it is liquid it has to be traded on an organised execution venue (Regulated Exchange, MTF, OTF, SI). At the time of writing this article ESMA had not published the latest draft of technical standards and the definition may change. A sellside company could be considered an execution venue for a buyside company.
Any institution that currently operates a trading platform for non equity instruments where clients can trade multilaterally will have to register as an Organised Trading Facility (OTF) if they want to continue offering this service to their clients. This will result perhaps in one of the largest disruptions to the current style of operations. Registering as an OTF carries its own obligations and is asset class based. Some institutions may decide to drop ‘marginal business’, and others may decide to invest in ‘marginal business’ to profit from business that others have dropped.
Outside trading, the processes around the creation, distribution and use of financial research will also be affected by the requirement to ‘unbundle’ its cost from commission or execution fees. This will create a separate set of contractual relationships to provide/source financial research. At the time of writing this piece there is no consensus as to how research should be paid for. This part of the directive may even change from one jurisdiction to another when the directive is transposed into national legislation.
Unbundling will affect sellside companies as they will have to charge for research and they will be restricted to providing financial research only to those who are requesting it (and hopefully paying for it). The greatest issue will be putting a value on something that has been distributed ‘for free’ for a long time and now has to be priced. This may also lead to a review of what is actually being produced and whether it is worthwhile. Buyside companies will also look at what research they use and what is valuable to them. At the moment, there is the perception that financial research is free; in the future, buyside companies will have to pay for it, so it makes sense to pay only for what is useful and valuable.
The implementation of MiFID II/MiFIR will undoubtedly change the way financial institutions work. The changes discussed above are examples of some of the expected disruptions and alterations to current business practice. Although ESMA will have published the latest definition of technical standards for MiFID II/MiFIR by the time this article is published, those technical standards will still be subject to the approval of the European Commission.
Prior to any implementation work there are strategic decisions to make. These can already be discussed based on the principles included in the level 1 definition of the directive and regulations approved by the European parliament last year and therefore cast in stone. These decisions are necessary to implement the best solution from the range of available alternatives.