The securities trading industry in Europe is facing one of the most far reaching changes ever. The application of the Markets in Financial Instruments Directive (MIFID) by market participants in the 25 EU member states is scheduled for November 1, 2007 and requires investment firms and regulated markets to adapt to significant changes in the area of securities trading.
MiFID is a centrepiece of the Financial Services Action Plan (FSAP) that aims at establishing an integrated and harmonised European market for financial services and products. MiFID was adopted on April 30, 2004 as a European Directive and contains 73 articles that have an effect on areas such as best execution, market transparency and organisational requirements.
Discussion of all the different aspects of this new piece of legislation would require a page coverage comparable to the full 'Handbook of World Stock, Derivative and Commodity Exchanges'. In this paper we will provide a brief overview on MiFID and the regulatory process and will focus on the requirements of MiFID that affect specifically trading venues and their market models. This will cover regulated markets, MTFs and systematic internalisers.
Regulatory process and timeline
The implementation of MiFID is based on the 'Lamfalussy Process' that subdivides the overall regulatory process into four successive steps named 'levels'.
On 'level 1', a directive (here: MiFID) providing framework principles is adopted by the European Council and the European Parliament based on a proposal of the EU Commission after intensive consultations with market participants. The 'level 1' directive defines the scope of the required implementation measures that are specified in 'level 2'. The EU Commission is responsible for the 'level 2' process and is advised and supported by the Committee of European Securities Regulators (CESR) and the European Securities Committee (ESC). These implementation measures can be provided in the form of regulations and/or directives. Regulations are directly effective in all EU member states whereas directives need to be transposed into national law by the respective member state. In 'level 3', CESR supervises the implementation process in the EU member states and finally in 'level 4' of the Lamfalussy Process, the correctness of the national implementation is enforced by the EU Commission.
At the time of writing (February 2006), the legislative process of MiFID is heading towards the end of 'level 2' and the EU Commission released the draft implementing measures to the ESC on February 6, 2006. The goal is to finally adopt these measures in summer 2006. The Commission provided the draft implementing measures in two documents: a regulation covering topics like transaction reporting, pre- and post-trade transparency and methods concerning the publication of client limit orders and a directive covering client order handling rules, best execution and organisational requirements.
Given this status of the process, the following remarks are based on the final MiFID ('level 1') text and the current information on the draft implementing measures. Collectively, these documents and the related background note of the EU Commission provide a basis to discuss and assess the impact on trading venues in Europe in the following subchapters.
Classification of trading venues
MiFID classifies trading venues into three explicit categories - Regulated Markets, Multilateral Trading Facilities (MTF) and Systematic Internalisers - with the fourth category 'OTC trading' implicitly defined in recital 53 of the Directive and covering transactions that are not allocated to one of the first three categories.
The trading venues are defined in Article 4 of MiFID:
- A Regulated Market is a multilateral system operated by a market operator where the instruments traded are admitted according to a defined procedure and the market is authorised and functions according to Title III of the directive.
- An MTF is also a multilateral system - it can be operated both by the operator of a Regulated Market or an investment firm. MTFs don't have the same obligations concerning financial instruments included into their quotation, and there are no specific requirements regarding the authorisation for the operation of an MTF.
- A Systematic Internaliser is an investment firm which, on an organised, frequent and systematic basis, deals on own account by executing client orders outside a Regulated Market or an MTF.
The fourth implicitly defined category (according to recital 53) relates to OTC trading which are transactions that are ad-hoc and irregular and are carried out with wholesale counterparties. Furthermore, OTC transactions are characterised by being part of a business relationship which is itself characterised by dealings above standard market size (as defined in table 3, annex 2 of the Draft Commission Regulation) and are carried out outside the systems used for systematic internalisation.
This categorisation defines the framework for the new regulatory requirements for regulated markets and investment firms. They affect amongst other things market transparency, market models and competition between trading venues. A market model of a trading venue can be characterised by three key structural elements:
- trading frequency and price determination,
- pre-trade transparency, and
- post-trade transparency.
The key requirements of MiFID and its implementation measures concerning these key structural parameters on market models of trading venues are analysed and briefly assessed below.
Regulated market and MTF market models
Under MiFID, the market model parameters for exchanges (Regulated Markets) and for multilateral 'off-exchange' trading venues (MTFs) will be explicitly defined and harmonised for the first time in Europe.
It is important to point out that the following provisions only relate to shares that are admitted to trading on a regulated market. Nevertheless, according to Article 65 of MiFID, the Commission has to report to the Parliament and Council on a possible extension of the instrument scope.
As the provisions for market models for both regulated markets and MTFs are largely similar they will be described collectively in the following sections.
Trading frequency and price determination
The MiFID 'level 1' text does not entail any specific requirements for these topics. Leaving the core function of 'producing the price' to the discretion of the market providers is key to fostering innovation and enabling competition among trading mechanisms.
Nevertheless, the 'level 2' draft implementing measures group market models explicitly into four categories in the context of pre-trade transparency obligations: continuous auction order book trading systems, quote-driven trading systems, and periodic auction trading systems (for a description of the system characteristics see table 1, annex 2 of the draft implementing measures). In order to provide for other market models and to avoid restrictions on market model innovations by being too prescriptive, the Commission provides a fourth category that covers hybrid models or market models of a different nature.
Pre-trade transparency
MiFID aims to harmonise the key parameters of and exemptions from pre-trade transparency requirements. These requirements are based on the above mentioned categorisation of market models in the 'level 2' draft implementing measures:
- Continuous order book trading systems shall make public the five best bid and offer levels including the number of shares and orders at each price level.
- Periodic auction trading systems shall publish the indicative auction price and volume.
- Quote-driven trading systems shall make public the quotes of each market maker.
This is in line with the existing models of most European markets and does not imply relevant changes concerning pre-trade transparency. Models of the fourth category (the remainder) are required to fulfil comparable requirements to those that are explicitly defined for the first three categories.
Article 44 of the MiFID 'level 1' text called for the Commission to adopt implementing measures concerning waivers from pre-trade transparency that are based on the respective market model, type and size of the order. The draft implementing measures grant exemptions for reference price systems - an important waiver e.g. for crossing systems like ITG Posit that are likely to be categorised as MTFs in a post-MiFID world.
Furthermore, the draft implementing measures enable waivers to be granted by the competent authorities in the case of negotiated transactions. Negotiated transactions are exempted from pre-trade transparency if they are executed at or inside the volume weighted spread or if they are subject to conditions other than the current market price of the share. Recital 12 of the draft implementation measures explicitly points out that the provisions on negotiated trades should not enable firms to circumvent their pre-trade obligations by shifting their internalisation activity to a regulated market or MTF.
Concerning order types, orders that are held in an order management facility (like iceberg orders or stop orders) are also excluded from pre-trade transparency requirements. With regard to the size of orders, the draft implementing measures exempt orders from pre-trade transparency if they have a minimum size (depending on the average daily order-book turnover executed on the most liquid market) between EUR50,000 and EUR400,000. As most open order book market models like Xetra or SETS as of today publish all orders that are submitted without any order restrictions by the market participants, it is likely that this will continue in the future and market participants will (as today) be able to hide bigger volumes by using icebergs or comparable order types.
Post-trade transparency
The MiFID requirements for post-trade transparency are largely in line with the existing market practices of regulated markets. The draft implementing measures define:
- the content of information,
- the requirement to make available post-trade information as close to real time as possible with a cap of three minutes, and
- the deferred publication thresholds and delays that are dependent on the average daily turnover of a share and the traded volume.
Concerning this last point, the delays/thresholds range from a delay of 60 minutes for a traded volume above EUR10,000 (in a share with an average daily volume below EUR100,000) to a delay until the end of the second trading day after the trade for a volume above 2.5 times average daily turnover (in a share with an average daily turnover equal or higher than EUR 50m.).
Systematic internalisers
Under MiFID, the practice of internalisation is defined and regulated for the first time across Europe. Although the definition of a systematic internaliser was already defined in the MiFID 'level 1' text (see above), most of the terms in the MiFID Article 4 definition (especially the terms 'organised, frequent and systematic') are not specified in MiFID but their specification is subject to the 'level 2' process. In contrast to the CESR proposals that included quantitative elements in the definition, the draft implementing measures - on a purely qualitative basis - classify an investment firm as a systematic internaliser if:
- the activity has a material commercial role,
- it is carried out based on non-discretionary rules and procedures,
- personnel and/or an automated technical system is assigned for this activity, and
- the activity is made available to clients on a regular and continuous basis.
Firms that fall under this definition face significant new requirements concerning their trading activities.
Trading frequency and price determination
Systematic internalisers apply a market-making type market model and are - according to Article 27 of MiFID - required to enable their customers to trade against their quotes continuously during normal trading hours. MiFID is also very prescriptive concerning price determination: Article 27 para. 3 insists on the execution of orders from retail clients at the quoted price and provides for price improvements only for professional clients and based on predefined criteria. The minimum size to allow for price improvement for professional investors is set at EUR7,500 (the size customarily undertaken by a retail investor) in the draft implementing measures.
Pre-trade transparency
The rules for systematic internalisers introduce completely new requirements for investment firms which are active in this business. The quote disclosure rule in Article 27 of MiFID requires systematic internalisers to publish firm and accessible quotes in liquid shares when dealing up to standard market size. Liquid shares are defined based on free float, average daily number of transactions, average daily turnover and they should be at least traded daily - for smaller EU member states a 'wild card' approach exists that enables them to include shares that are not fulfilling the requirements for liquid shares as defined in the implementing measures. For non-liquid shares, quotes shall be provided on request.
MiFID requires that the quotes are easily accessible to retail or professional clients without discriminating within those groups. The quote size can be individually defined by the systematic internaliser enabling firms to reflect their individual business models in the quoted size and allowing smaller firms to quote lower sizes than the standard market size (even as small as one share). Nevertheless, they are obliged to execute orders that are larger than their quoted size and smaller than the standard market size at the quoted price if they decide to internalise those orders.
Post-trade transparency
The requirements for post-trade transparency are applicable to all investment firms irrespective of their status as a systematic internaliser. MiFID imposes significant organisational and technical changes on investment firms in countries like Germany where no post-trade transparency obligations for OTC transactions yet exist. The requirements as such are comparable to the ones that also apply to Regulated Markets and MTFs (see above).
Summary and outlook
To sum up, concerning the market models of regulated markets and MTFs, the MiFID requirements are largely in line with the existing structures of European trading venues. They sustain flexibility for the operating institutions to define a wide range of models.
Nevertheless, the models are subject to widely harmonised transparency requirements. It is key that all exemptions concerning those transparency requirements are handled in a consistent manner by the member states in order to avoid regulatory arbitrage. The usage of a regulation instead of a directive to cover the transparency requirements in 'level 2' is an important step in this direction; but one has to keep in mind that the waivers are finally granted by the competent authorities of the respective member states. MiFID implements a consistent concept of functional regulation where regulated markets and MTFs are aligned as much as possible, but only as far as necessary.
Regarding internalisation, the EU legislative authorities and the firms themselves are turning over a new leaf. Both the definition and the requirements on systematic internalisers have been hotly debated since the initial MiFID discussions in 2001 (when MiFID was named ISD2). The new regulation on the one hand eases off-exchange execution by abolishing any possibility for member states to impose concentration rules; on the other hand, the new requirements impact on the business models of investment firms which are active in the business of internalisation.
Due to the significantly increased related regulatory costs and increased trading risks, firms will scrutinise intensively their existing internalisation models and will likely apply much creativity to circumvent being captured by the definition as a systematic internaliser. It can be assumed that only big firms will continue with or take up this business model, and if they decide to do so, they will try to achieve economies of scale by acquiring additional order flow from smaller firms applying preferencing agreements. It is key that the Commission performs an intensive and thorough review (as laid out in Article 65 para. 2 MiFID) on the requirements for systematic internalisers, as their fine-tuning is crucial to achieving the key goal of MiFID concerning trading venues: the balance between competition that encourages innovation on the one hand, and the efficiency of the price discovery process on the other.
It should be kept in mind that the aspects of the new legislation discussed in this article only cover a specific part of MiFID. Topics like best execution, transaction reporting or client order handling that primarily address investment firms will obviously also affect, directly or indirectly, the trading venue landscape.
In total, this Directive will change the trading landscape fundamentally. As Charlie McCreevy, European Commissioner for Internal Market and Services puts it:
'MiFID will be the catalyst for significant market changes. It will dramatically increase levels of competition among and between execution venues and investment firms. Indeed, my services tell me that this may be the toughest securities law dossier they have ever had to deal with!' 1
Notes
1 McCreevy, C, Stock market consolidation and security markets regulation in Europe, Annual Lecture at SUERF (Société Universitaire Européenne de Recherches Financières), Brussels, 30 November 2005.
