Although it required a heavy lift from the financial services industry, the Mifid II implementation deadline came and went with minimum disruption. However, as Galen Stops points out, the real change is still yet to come.
So here’s the good news for the FX industry: the January 3 Markets in Financial Instruments Directive (Mifid) II implementation deadline passed without any significant market disruption at the start of this month.
“January 3rd went relatively smoothly, our members generally reported a largely uneventful launch although the industry is continuing to work through a number of minor issues, which is what you would expect at this point in time,” says James Kemp, managing director, Global FX Division, Global Financial Markets Association (GFMA).
However, contained within the very next sentence uttered by Kemp is the bad news: “One thing to bear in mind though, is that January 3rd was only the starting point, with other obligations going live in coming months. So it’s likely to take some time for all of the effects of MiFID II to kick in and become apparent,” he says.
For example, the best execution requirements contained within MiFID II haven’t gone live yet. Data collection has started, but the first report isn’t due until April 30, meaning that the industry has no idea yet how effective its efforts towards managing and submitting data has been. Some firms have opted in to be a systematic internaliser, but there’s no central database about which firms have and haven’t opted in and the calculation of whether certain firms are required to be systematic internalisers doesn’t go live until the end of September.
Alex McDonald, CEO of the European Venues and Intermediaries Association (EVIA), says that what the FX industry witnessed on January 3 was effectively a soft launch of the new regulatory requirements in the guise of a live testing environment.
But despite this, he points out one significant change for the FX industry that did occur.
“FX markets do not give the appearance of having changed a lot in the new year, because a lot of product is illiquid and many participants are not EU investment firms, and so are afforded some respite from MiFID II. But what you can’t make light of is that with the start of MiFID II on January 3rd, the whole provision for making FX forwards financial instruments in the EU came into effect, which changes the post-trade and market abuse environments quite a lot,” explains McDonald.
On top of this, it seems that MiFID II could have a broader impact on financial markets in the years ahead by creating an artificial boundary between products and market participants that are caught “in-scope” of the regulation and those that are able to remain “out-of-scope”.
There is already some circumstantial evidence of this trend emerging. McDonald notes that, prior to the MiFID II deadline, EVIA members were concerned that trading firms wouldn’t have their Legal Entity Identifiers (LEIs) in place and therefore might not be able to trade. In response to this concern, the UK’s Financial Conduct Authority (FCA) and the European Securities and Markets Authority (ESMA) together rolled out a workaround for this problem in late December, which means that for the first six months after the January 3 deadline, firms can conduct a trade and then get an LEI for the trade up to a week later.
“But none of our members are finding that people without LEIs are trading. This probably means that people without LEIs are happy not to enter into the scope of MiFID II,” says McDonald.
He continues: “One risk we see arising is that the regulation builds a hard boundary dividing EU firms operating and trading in MiFID II, whilst non-EU firms decide that it’s more straightforward not to be in MiFID II. In this case, we will likely witness dollar liquidity concentrating back into America and Asian liquidity remaining firmly in Asia with, “Non-EU persons” as market participants further subsidiarise.”
The in-scope/out-of-scope divide also presents a challenge for FX platform providers in Europe, especially because FX is a global product that has been traditionally booked into London under UK law and many transactions consist of multiple legs.
Again, McDonald explains: “One of the more pressing issues for the FX platforms has been whether they want to export their MiFID II perimeter around the world and whether spot market liquidity is effectively conjoined as a “permitted product”. This has raised questions around the onboarding of global clients into MiFID II, or whether they want to draw certain lines and create certain functionalities outside their operational perimeters of MiFID permissions, persons and products. Both come with their challenges.”
Buy side firms are also looking for ways to stay out-of-scope of the MiFID II requirements. Multiple market sources in Europe detail instances of investment managers changing their regulatory permissions to operate under an Alternative Investment Fund Manager Directive (AIFMD) license so that they avoid the MiFID II requirements.
Of course, the in-scope/out-of-scope issue becomes even more complicated with Britain’s impending departure from the European Union. David Clark, chairman of the EVIA, predicts that Brexit could have a significant – and negative – impact on the macro trading side.
“Liquidity has been fragmented unintentionally by Dodd-Frank and MiFID, which increases the incentive not to hedge as much as you did in the past if you’re a mid-size corporate. That all goes to increased risk, and in financial markets higher risk means higher capital and liquidity requirements. The combination of MiFID and the uncertainties of Brexit serves to increase risk and costs, which act as a disincentive for some firms to hedge and increases the amount of capital and liquidity required in the system. None of which is a sensible or good thing, and this is going to hit everyone,” he says.
Elsewhere, Adam Jacobs-Dean, director, markets regulation, at the Alternative Investment Management Association (AIMA), warns that Brexit will “fundamentally change” the Mifid II passporting framework.
“As it currently stands, if you’re an established investment firm and you want to passport your service straight through the rest of the EU, it’s fairly straightforward. But that will potentially disappear overnight if we end up with a Brexit deal that means the UK has to move to third country status,” he says.
And even the third country status prescribed by MiFID II is viewed as problematic by some segments of the market.
“Related to Brexit is the whole third-country issue. MiFID II has very good objectives in terms of transparency and investor protection, but there’s also a protectionist angle to the regulation which is concerning to our members. If the objective is for the markets in the EU to have deep and broad liquidity, then closing off European markets by way of regulation isn’t conducive to that,” says Piebe Teeboom, secretary general of the FIA European Principal Traders Association (EPTA).
He adds: “Fortunately, many member states have taken a fairly pragmatic view regarding third party access to exchanges for firms that deal on own account. This certainly helps to prevent the tapering of liquidity on the markets in those member states. But there’s no guarantee that this approach will continue once we move to a pan-European harmonised third-country market access regime, which will kick once the national regimes end.”
Another area of concern for FIA EPTA members is the collateral damage of being in-scope of MiFID II from a prudential perspective. On January 3, Teeboom estimates that about one-third of the association’s membership came into the scope of the regulation, meaning that they are now subject to prudential rules and European capital requirements regime that were developed for banks, which he says are therefore very risk insensitive and unsuitable for investment firms.
“The risk is that these will have a very negative impact for market makers and their ability to provide liquidity to the market,” says Teeboom.
The European Commission is currently in the process of developing a new prudential regime specifically for MiFID II investment firms, but that proposal was only published at the end of last year and is likely to be subject to continued negotiations and changes going forward, meaning that it will take a significant amount of time for it to actually be implemented.
Although there are clearly some significant challenges that firms will have to continue grappling with as the true impact of the rules continues to become more evident, some are beginning to see some light at the end of the tunnel.
“We’re now entering a phase of post-reform optimisation. What I mean by this is that we’re at a point where we have the intersection of these three pillars – market regulation, prudential regulation and the whole conduct agenda – in place and coming to a head and as a result, we now see firms looking to the future and being able to focus on their businesses once more.
“They’re looking at how they can rationalise all of the technology that they’ve put in place, they’re looking at the client services and offerings they have in place and looking for ways to improve them. It’s been a huge lift, but I think that there is a turning point where firms can now increase the focus on their businesses, within the parameters of the new regulatory framework,” says Kemp.
Meanwhile, Jacobs-Dean predicts that all of the post-trade data that buy side firms will now see on the non-equities side will potentially begin to change how they trade.
“I think that at this stage, firms are still getting their heads around how they might make use of all the market data that now exists under MiFID II, but I think it’s pretty much guaranteed that firms will be looking to make maximum use of that data in their trading strategies. If you’re better than your peers at consolidating that data and using it to inform your trading strategies, then it could actually be a big help in terms of profitability and having a good trading strategy,” he says.
Furthermore, Jacobs-Dean notes that the more organised trading environment that MiFID II brings in, including the trading obligation and the OTF structure, will benefit firms that have a niche in terms of electronic trading. In particular, he says that firms will look to capitalise on the greater prevalence of electronic trading that the rules will bring to markets that have historically been more voice traded. Jacobs-Dean adds that, because there will be a greater availability of products on electronic trading platforms, firms that have low latency strategies will have a broader range of opportunities in terms of which products they might be able to trade within those strategies.
Ultimately, while MiFID II is likely to have a significant impact on how financial markets in Europe are traded, it is hard at this early stage to predict exactly where and in what form these changes will become apparent.
As McDonald points out: “MiFID I didn’t seem that revolutionary as it happened, but then it quickly led to many initiatives including dark pools, HFT and changes in equity market structure. You might argue that MiFID II may also initiate huge “RegTech” and “FinTech” revolutions based upon plentiful and standardised data sets, which could encompass all-to-all trading and lots of different forms of arranging liquidity, be it all-to-all RFQ in some other functionality or CLOBs where the instrument changes rather than the CLOB, or other initiatives of that sort.”