MiFID under the microscope

On 1 November the Markets in Financial Instruments Directive, or MiFID as it is more commonly known, came into effect in 30 countries – almost four years after it first entered the statute book. This new regulatory framework for financial services in Europe replaces the Investment Services Directive (ISD) introduced 12 years ago. In the short term MiFID is sure to have finance chiefs counting the cost of its implementation. Indeed, the UK's Financial Services Authority (FSA) expects compliance to cost the sector around £1 billion. On top of this there will be an explosion in data and increase in the number of execution venues.

But are the institutions ready for the change and what is the outlook for the next 12 to 36 months as they prepare themselves to seize new opportunities? These are just some of the questions that BearingPoint's Alan Jenkins investigated in a recent report he compiled – 'MiFID beyond 2007: Impact on market structure'. So are the financial firms geared up? FST asks. Jenkins recounts a news article he saw recently on the subject. "There was a wonderful headline on a news site in November headlined 'Brokers are complaining' – as if they had no way of knowing that this was coming."

For the 27 EU members, plus Norway, Iceland and Liechtenstein, it has been somewhat a scramble to transpose MiFID Level 1 and Level 2 directives into national law and their national regulations accordingly. This transposition was to have been completed by the end of January 2007, but even by the close of June, less than one third of the countries had managed to meet that obligation. However, BearingPoint anticipates that the MiFID regime will be up and running by early 2008.

Despite MiFID's much-publicised arrival, Jenkins foresees many firms taking a wait and see approach by stalling for the first 12 months. "There is a critical date that is 12 months after MiFID was introduced so you can kind of bury your head in the sand and ignore what is happening for up to a year. I am sure a lot of people will wait for the first anniversary but after that there will be no excuses." Also after 12 months, CESR (The Committee of European Securities Regulators) and the European Commission will conduct a review of how certain aspects of the directive are working. "And eighteen months after launch, investment firms can expect some fine-tuning of the regulations, based on practical experience," says Jenkins.

All change

The industry also expects to witness a growth in multiple execution venues, which will lead to competition between these venues to offer the best practice. This will challenge the institutions as the search for finding best value in a fragmented market begins in earnest. "The key here is the investment in technology," Jenkins explains, "because the same stock is being traded in five, seven or nine different venues and not just at different prices but also with different trading costs – because some venues will charge a flat fee; others will charge ad valorem basis points. So working out the best place to route any particular order is non-trivial, and you can't expect people to do that in their heads – you need rule-based systems to do that."

Adopting of these systems could separate the winners from the crowd. "Those firms that invest in smart order routing, sometimes called Execution Management Systems, will be the survivors and the winners," says Jenkins. Calculating the best venue for a particular client order will become much more challenging. Those firms that invest in smart order routing systems are likely to be positioned than firms that are reluctant to do so. This could make life difficult for the smaller, traditional, national players. "By and large, I think that it's likely to be the bigger firms that do that so we'll see some polarisation. I think we'll end up in two or three years' time with somewhere like 10 to 15 significant pan-European players who do have this technology, and I think a lot of other firms, particularly after that 12-month review, are going say it's not worth it."

Of course, the post-MiFID environment will lead to significant technology changes, which could create problems for the traditional exchanges. "All these new venues are going to communicate with using the fixed protocol, and that makes it very easy to plug and play with them; and yet it also leaves the traditional exchanges a bit stranded with proprietary interfaces and even the proprietary networks in some cases," Jenkins muses. Speed, something that is vital and not just a desirable, is also an issue. "There's also the challenge latency – getting orders turned around in milliseconds rather than fractions of a second."

BearingPoint’s report found that another technology challenge is the lack of adoption of standards. Almost every national stock exchange, clearing house and depository has its own proprietary application programming interface. “It’s now surprise, therefore, that MiFID has focused the financial services industry on standard protocols,” says Jenkins.

And while the first 12-18 months are expected to see both data and execution venues swell considerably, Jenkins believes this situation will reverse in the long term. "We believe the pendulum will swing back during years two and three. With experience, financial services firms will discover which venues are the most efficient and will businesses to them." The study also anticipates that the intermediary firms, both buy and sell side, will have to deal with much stiffer competition and greater transparency, which is bound to impact on their margins. “Only a relatively small number of the best prepared will survive, including those that bridge the gap between the traditional (pre-MiFID) buy and sell side,” Jenkins wrote in his report. BearingPoint also believes that some outsourcers providing MiFID-supported services will become experts in the new regulatory requirements. As a result, they will gain business from financial services firms that do not want to make the investment in coping with the new rules in-house.

Outlook

However, once the dust settles, who will come out of top. Jenkins identifies domestic exchanges and intermediaries as being most at risk but national firms that operate pensions and other tax-sheltered tax 'wrap' programmes, such as ISAs in the UK, may well continue to find a market. It's also unclear what impact MiFID will have on non-European tax havens such as Switzerland, Monaco or Jersey and whether investors will want the to get the benefits MiFID investor protection. This raises a larger issue, remarks Jenkins. "After Sarbanes-Oxley, there has been a huge decline in international firms listing in the United States and a corresponding increase in listings in Europe." This backfired badly in the US. "Critics say this shows that US authorities shot themselves in the foot by over-regulating. Will MiFID produce similar results, or does Europe have the balance right? The answer to that question will only emerge several years from now"

About Alan Jenkins

As well as being BearngPoint’s European lead for MiFID, he co-chairs the Cross Jurisdiction subject group within the MiFID Joint Working Group, and has also represented BearingPoint on the Enterprise Data Management Council. A frequent public speaker, Jenkins previously worked both for participants and for service providers in the Financial Markets.