MiFID: More than words

MiFID. Massive Interruption from Interfering Diplomats? Much Infighting, Facilitating Incompetent Directive? Magnificent in Form, Incision, Detail? Many Investment Firms in Disarray? Or, Markets in Financial Instruments Directive? MiFID is the new regulatory framework for financial services in Europe, which will replace the Investment Services Directive (ISD) that was introduced in 1996. It forms one of the cornerstones of the European Union’s 42-step Financial Services Action Plan.

In general terms, MiFID builds upon the principles already set out in the ISD, by expanding the scope of the directive and tightening requirements. Nearly all firms that are covered under ISD will continue to be affected under MiFID, and in many cases the requirements placed upon them will be far more comprehensive. MiFID is being introduced using the four-level Lamfalussy procedure. The requirements of the second-level directive were published on 2 September 2006 and will come into force on 1 November, giving firms time to implement any changes necessary in order to comply with the new set of regulations.

Same, but different

While MiFID builds upon the ISD, there are a couple of important departures. Under ISD, emphasis was placed on mutual recognition between member states. MiFID introduces the concept of maximum harmonisation, whereby member states cannot gold-plate the EU requirements, for example giving harsher penalties for non-compliance.
A major divergence of the two directives is the abolition of the concentration rule, which permitted member states to require all retail investor transactions to be executed on a regulated market. This will have the effect of exposing many stock exchanges in member states to competition for the first time, although not all EU states took up the option in the first place.

In the short term, MiFID will only have one immediate impact – it will be expensive for firms to implement. In the UK alone the FSA expects compliance to cost firms around UK£1 billion, with the most expensive transition in the execution, client categorising and systems and control sectors.

Lower administrative burdens

MiFID will drastically increase the administrative burden on financial institutions. Records of all equity transactions have to be kept for five years after a trade has taken place to satisfy the new post-trade transparency requirement. This may be a positive development for the investor, as the best prices for European equities will be known Europe-wide all the time. Whether the costs of implementing such a change outweigh the investor benefits in the market remains to be seen, but it is likely that the effect of data collection on such a massive scale will be of substantial benefit in the market for very few. This is because many investors will not have the time, will or inclination to number-crunch that much data, ensuring that this requirement serves more as generic red tape than as a useful compliance measure.

The implementation of MiFID brings a massive change in the nature of regulation that an institution undergoes for any products and services it offers. Under ISD, if a firm made transactions with a resident of another member state, it was regulated by the member state in which it offered the transactions – the host state. The introduction of MiFID will bring a key change for companies making such cross-border transactions: any products or services offered cross-border in another member state will be regulated according to the regulations of the country in which the firm is located – the home state.

This will have the effect of reducing the barriers to pan-European expansion for small- and medium-sized firms, as the legal costs associated with ensuring compliance with local laws will have been removed. However, the impact may be limited by the host state rules continuing to apply to products and services offered by branches of the firm in the host state. The position of who regulates the branch’s activities in other member states is unclear. MiFID should benefit the equity market, as it will enable firms to offer their portfolio of products across a wider geographical area more easily and cheaply due to the diminished legal costs. It is likely that this will lead to more medium-sized firms driving expansion to offer products directly without branches outside their home market than chose to under ISD, because the extra cost of compliance with local regulations in other markets was prohibitive.

This should result in giving investors greater choice, and therefore greater opportunity to match a product more exactly to their requirements, allowing the European markets to allocate assets more efficiently. In turn this will enable growth maximisation in the European sector.

Reduction in state power

The aspect of MiFID that will have the greatest impact on equity markets, however, is undoubtedly the extension of regulation to systematic internalisers – where a firm acts as a mini-exchange by crossing orders it has on its books internally. In conjunction with the removal of the concentration rule, MiFID will significantly reduce member state power over exchanges. By opening up this area of the financial market to competition, there is a significant chance of cost savings for clients as standard market mechanisms remove uncompetitive exchanges from the market, lowering the absolute cost of trading.

Costs to clients may be reduced if exchanges converge due to the reduced state-imposed control. Here, there will be some synergies giving cost savings to both clients and operators. From the opposite perspective, the impact of opening up exchanges could lead to an even more fragmented European equities market, as the number of exchanges, and therefore the number of quotes for any given equity, increases substantially. With the enhanced requirement for firms to prove best execution to clients, this could prove to be a minefield for financial institutions, significantly increasing the cost of trading.

However, firms with a comprehensive IT infrastructure can develop their systems to provide the price-checking and record-keeping stipulations of MiFID. It also makes sense to assume that for any equity the price Europewide will be very similar, since the market will immediately remove any discrepancies if there is a chance for arbitrage.

Passport to more services

MiFID has simplified the concept of a passport introduced with the ISD, clarifying some of the jurisdictional uncertainties. For example, a firm that provides cross-border services will only be subject to home state requirements. This, again, ought to drive competition in the market, which may have the effect of desegmenting it and reducing the amount of monopoly exerted by some very large financial institutions.

With greater competition should come better practices and reduced costs, which will be passed on to clients, driving growth in all markets, including equities. If the savings associated with the new passport turn out to be substantial, it may lead to smaller firms completely relocating to another member state with favourable regulations and then passporting all their services, increasing efficiency and the associated benefits further still.

If MiFID is implemented successfully, the analysis suggests the consumer should benefit from the increased transparency financial firms are forced to abide by. That observation, however, comes with a caveat. It would be unreasonable to assume that the cost of compliance, both one-off and ongoing, will be entirely absorbed by the financial firm, and some of these costs will invariably be passed on to clients.

As MiFID is implemented, the equity market may be suppressed in the short term as the cost of compliance is factored in to pricing. As well as costing the UK about UK£1bn to implement, there will be ongoing costs of UK£200m to UK£270m, in an economy worth more than UK£1 trillion. This can be seen as negligible in terms of GDP and similar ongoing costs are likely in other member states.

Potential benefits for markets

However, another possible outcome of the cost of compliance is a rise in the number of mergers between smaller firms so that, far from increasing competition via simplified regulations, competition decreases because some firms are not able to overcome the first hurdle. The effect MiFID will have on the equity markets will depend on the overall impact that it has on European financial institutions. It is still possible that national governments will intervene, despite the measures introduced to prevent gold-plating of the regulations, which will reduce the enhanced European integration MiFID sets out to achieve. The benefits arising from the implementation will then be limited, although compliance costs must still be met.

It is also possible that natural economic factors such as physical location will dominate any regulatory framework imposed by the EU; while MiFID may remove barriers to integration and stimulate the equity markets with reduced costs and lower spreads, there will be a limit to how far its impact will reach.

MiFID will have a significant impact on the European financial climate. It represents a substantial shift in the principles of regulation, which appears actively to encourage integration between member states. This will help the creation of a single European market for investment services. A single market will breed enhanced competition, and should stimulate the equity markets. The transition period may be difficult as firms struggle with the breadth of IT measures they need to implement, and undoubtedly there will be some merger activity, but a stronger and more clearly defined investment services framework should emerge.

Clients Europe-wide can achieve improved efficiency and lower costs of trading, so, in the longer-term, the European equity markets should emerge stronger than they would be without MiFID. Four definitions of MiFID were given above. The most appropriate is ‘Many Investment Firms in Disarray’. This is almost certainly positive, because once in a while every industry needs to be shaken up in light of new technology and working practices. MiFID should accomplish this in the European financial markets.