With implementation set for 2018, regulations strengthening investor protection and reforming market structure will affect every part of the securities-trading value chain: trade execution, investor protection, reporting, and settlement. Taken together, the measures of the new Markets in Financial Instruments Directive and Regulation (the MiFID II rules) will alter the way the buy side monitors and manages trading costs and related services, according to a new report byMarkit and The Boston Consulting Group (BCG). The report, MiFID II: Preparation Without Delay, is being released today.
The report aims to help market participants anticipate and prepare for the coming market transformation. It gives an overview of the new MiFID II rules, the effect they will have on the market structure, and what they will demand of market participants by way of enhanced capabilities and investment in them. There is a particular focus on investor protection, derivatives and bond trading, and trade analysis.
“The European financial markets of 2020 will look nothing like 2015,” said Philippe Morel, a coauthor of the report and the global leader of BCG’s capital-markets segment. “By increasing automation and transparency, MiFID II will change the economics of securities trading. New data management and analysis capabilities will be required, old sources of revenue will decline (or disappear), and new players will enter parts of the value chain.”
The liquidity landscape will also be affected through the tiering of securities and trading-venue standards, requiring a deeper understanding of shifts in trading behavior and costs.
“Liquidity shifts, particularly in the bond market, can happen very fast in times of market stress,” Michael Aldridge, global head of trading services at Markit said. “This is unlikely to be captured in the basic liquidity assessment required by MiFID II. The requirement for a solid best-execution policy and the ability to explain the rationale to regulators will create the environment to develop trade cost analysis across asset classes.”
Paying for Research. Upcoming MiFID II restrictions on inducements will end the current research payment model by severing the link between execution and research. A two-tiered model for research provision is likely to emerge, with investors choosing between basic provision and high-value additional services. Increased clarity about the cost of research will result in more analysis of its value. There is evidence that the unbundling of commissions has reduced investment-banking equity-research budgets. These are expected to fall 25% by 2020, according to data from BCG, causing some banks to start scaling back research offerings in European equities.
Toward Best Execution. Under the new rules, firms must take into account price, cost, speed, likelihood of execution, and size of trade. Extending best execution requirements to fixed income and OTC derivatives creates particular problems. The investment process of many fixed-income managers does not result in firm orders in specific securities. Asset classes with lower electronification rates, such as credit, are more exposed to trading-data shortfalls. Regulations will require data tracking and management that can exceed the present capabilities of investment firms.
The Fixed-Income Case. Fixed-income markets are going to be particularly affected. Data from Markit shows that 46% of European bonds are traded one day or less per year, according to bond quotes plotted against modeled trades. As dealers will be held accountable for publishing executable quotes on bonds, the number of quotes and trades may fall as dealers avoid quoting on bonds they don’t want to trade, further reducing liquidity.
Trade Analysis. Asset managers will need to understand how their transaction will be treated under the transparency requirements, depending on the size and type of transaction, as well as the different types of dealer or venue they are dealing with. Fixed income has historically been a low user of transaction cost analysis because of the inherent opacity of the market and the reliance on manual processes and inputs. As a result, we expect significant growth in fixed-income cost analysis and in the use of analytics that assess the full cost of execution options.
After the initial push for compliance, said BCG’s Morel, investment firms will be in a position to benefit from updated technology and sophisticated trade analysis. “The disruption will be significant.” he said, “By integrating predicted trading costs into the portfolio construction and selection process, managers can guard against additional costs arising from changes in the market structure.”
A copy of the report can be downloaded here.
