The UK’s Brexit vote to leave the European Union sent a shock through financial markets, but will it throw Britain’s compliance with MiFID II into a tailspin? From a legal standpoint, Britain is still under the jurisdiction of existing European laws for at least the next two years. Prior to the vote, pundits said that buy- and sell-side firms would be subject to MIFID II’s rules since the implementation date is January 2018.
The UK government officially notifying the EU of its intention to leave (under the provisions of “Article 50“) will trigger a two-year period of complex negotiation between lawmakers in London and the EU to rewrite trade agreements and laws that tie the UK to the European Union, according to Law 360’s Capital Markets report on the morning after Brexit’s vote.
Yet, there are already doubts about MiFID II, a colossal set of centralized securities investment and trading rules designed by Brussels-based regulators that are subject to approval by the British government and Parliament.
“UK investors are questioning whether certain aspects of MiFID II — volume caps on dark pool trading, the ban on broker crossing networks, and the transparency regime for illiquid fixed income securities — are really in the best interest of the end investor,” wrote buy-side consultancy, K&K Global Consulting.
MiFID II also takes a hard line on unbundling research and executions, which will upend the sell-side business models and potentially force investment firms to pay in cash or be required to set up research payment accounts (RPAs). The RPAs are a new twist on commission sharing agreements or CSAs, which allow the buy-side to accrue their commissions with brokers, and separate the execution component from the research component.
To force the unbundling of research from trading commissions, the RPAs would require asset managers to set a monetary budget for research that would not be tied to transaction volume. Asset managers and hedge funds that can use client money to pay for research would set up an RPA. Firms that cannot use client money must pay for research directly or fund the RPA themselves. However, there is industry confusion over whether CSAs can co-exist with RPAs. The delegated acts leaked in December suggested that CSAs could co-exist.
“MiFID’s changes to rules on best execution will have a profound effect on the way that brokers and asset managers operate,” said Spencer Mindlin, senior analyst at Aite Group on the June 8th webinar “Pain Points and Impact of MiFID II/MiFIR. Pointing to the volume caps on dark pool trading, Mindlin said there could be less liquidity available for trading. “This could limit an investment manager’s ability to deliver what he/she perceives to be best execution,” said Mindlin. Under MiFID II, a single dark pool is limited to 4% of the volume per stock, while all dark venues are limited to 8% based on the rolling 12 months. If a dark pool exceeds the 4% threshold, trading is banned for six months, said Mindlin. Uncertainty also surrounds how ESMA is going to monitor the volume levels and how the venues are going to coordinate their trading so as not to trigger the 8% limit. “My understanding is that ESMA is going to get feeds from the dark pools twice a month or monthly,” said the analyst.
Even with the UK voting to leave the EU, it still has to follow the MiFID II regulations for dark pools. Currently the dark pools account for 11% of volume across all stocks. However, larger in scale or block orders are exempt from the limits and can be routed to and matched in dark pools, he said. While the goal of policy makers is to provide additional transparency and to protect the integrity of prices in the lit markets, maintained by exchanges, even before the Brexit vote, Mindlin said the 8% threshold seems to be arbitrary.
Since many of the dark pools or multilateral trading facilities are Pan European venues, by imposing the caps, regulators can encourage volume on their exchanges. “There is a big push toward nationalism, that plays itself out with stock exchanges,” said Mindlin. The Brexit vote could also influence the outcome of the $20 billion merger between the London Stock Exchange and Germany’s Deutsche Boerse, which is based on the business rationale of European integration. Both exchanges issued statements that the merger is moving forward and “was never conditional on the outcome of the referendum.” However, sources told the International Business Times, IBT, that the Brexit vote could influence the approval of the merger in Germany, and regulators are asking for the headquarters of the merged entity to be based outside of London.
There’s no question that buy-side firms operating in Europe are bracing for a more expansive best execution requirements that has wide ranging consequences for the buy-side, but there are still ambiguities about interpreting the guidelines.
ESMA has upgraded the best execution requirement from “reasonable” efforts in MiFID I to taking all “sufficient” steps in MiFID II. The legislation will require that asset managers take “sufficient” steps to obtain best execution for a client, considering price, cost, and speed, likelihood of execution and likelihood of settlement.
“Whether this definition is merely an exercise in semantics or matters in practice, will depend on how much teeth regulators put into enforcing the rules,” said Mindlin
While MiFID I introduced a multi-factor approach to determining best execution, MiFID II rolls out several new disclosure requirements. Investment firms also must make public the top five execution venues (on an annual basis) where they executed client orders in the preceding year along with specific data related to execution quality on the venue. They must do this for each class of financial instruments.
Aite Group suggests that firms will need to monitor their executions and order routing to brokers more intensely on an order-by-order basis.
In the past, when a regulator showed up, firms could provide a regulator with a random sampling of a few trades per quarter. Then the firm would cobble together a report with trade details. They might create this report of a couple of trades upon request, says Mindlin. But this is unlikely to be adequate in the future, suggested the analyst. Now, there is a sense that investment firms are required to do this for every order.
Trading firms will need to adopt workflows that allow them to demonstrate how they achieve best execution, said Mindlin during the webinar. “The main takeaway is that best execution to take all sufficient steps is going to put wind in the sail of electronic trading.”
But the UK’s Brexit vote could also have an impact on one of the more controversial aspects of MiFID II – the transparency rules with respect to fixed income.
MiFID II’s delegated acts expand the best execution requirements to cash bonds, derivatives and FX forwards.
The buy-side has repeatedly expressed concern for transparency in fixed income, wrote K&KCG in its blog, noting that too much transparency could damage liquidity.
Buy-side firms who trade illiquid securities or OTC products are apt to face the most far- reaching impact from the regulation, noted Aite Group.
“In terms of fixed income, the reality of an OTC market without a central-record of prices or volumes is going to make this challenging, especially for illiquid securities that don’t trade for days or weeks,” said Mindlin. “It’s very hard to measure transaction costs for illiquid corporates, some of which don’t trade for days or weeks. Firms are going to need an aggregation of prices from various sources to determine a fair value of those bonds,” he said.
If that’s not helping, then the buy-side may have to do their own implied valuation to figure out what a bond is worth. Some technology providers are offering request-for-quote (RFQ) solutions to provide an audit trail for illiquid and bespoke products. RFQ technology will enable buy-side traders to set up their own RFQ for capturing bids and offers. With the lack of centralized price feeds for bonds, Aite sees a need for indicative valuation and manual comparison of competing quotes to fuel TCA for fixed income.
Another issue is that under MiFID II buy-side traders are required to consider “the likelihood of settlement” as part of their execution decision. “There are significant problems if the trades fail because the broker fails to deliver,” noted Mindlin. “You may only see the price they are giving you, but not see that the broker has a history of failing on trades,” he said. “The trading desk is going to get that information from the back office or middle office because the front office is the one that needs to show how it routes orders to brokers,” explained Mindlin.
“Someone trading an illiquid bond or an OTC derivative is going to be more exposed to inspection. A regulator is going to want to see that the firm factored in five-or-eight criteria into their decision making tree. However that grand vision may not work, said the analyst. It might be more of a manual process, where every month the front office looks at a settlement report, and figures out which broker to route orders to,” he said. Applications such as an integrated book of record, or IBOR, can take information from the back office or middle into the hands of the front office. This is one way in which firms can prove they considered settlement in the multi-factor model of best execution.
With Britain pulling out of the EU, the impact on the specific aspects of MiFID II remains to be seen. The FCA has reminded UK firms that they “are obligated to abide by UK law, including those derived by EU law and continue with implementation plans for legislation that is still to come into effect.”
According to buy-side consultancy K&KGC, the end of the UK’s relationship with Europe throws into question the longer-term arrangements of the UK with regard to MiFID II.
However, one view is that UK firms will require some kind of MiFID II “equivalency” reforms put in place in order to continue doing business in Europe.
It’s also possible that UK lawmakers and authorities will be able to pick and choose the aspects of MiFID II that they like and reject the ones they don’t like. But this can open up a Pandora’s Box of unintended consequences as the UK’s rebellion plays out against the uniformity envisioned by European regulators.
