MiFID, the EU & You
The importance of regulation in financial markets
“A smart man gets out of problems a wise man wouldn’t get into.” (Prof. M. Rubinstein)
On February 15th, 2001, the European Council received its report from a Committee of Wise Men on how to make investment legislation more flexible, effective and transparent. This ‘final report’ was adopted a month later and remains one of the singular incidents in history where a problem was addressed by the body politic before it actually arose. The Wise Men’s Committee was headed by the Hungarian-born Belgian economist and central banker Alexandre Lamfalussy; and the ‘Lamfalussy process’ has become the basis for the EU’s financial service industry regulation – MiFID.
MiFID, or the Markets in Financial Instruments Directive was legislated less than 3 years after the report – an uncharacteristic short period, when it comes to EU activities.
MiFID – Shark Protection
Similar in character (if not in substance) to the US-generated financial calamity that generated a world war, 2008 was also the result of unscrupulous brokers preying upon the uninformed. Today, news is instantaneous, infinitesimally fragmented and delivered online to anyone who cares to indulge. But access to the news is one thing – access to the means of monetizing it is a relatively recent development.
Today, more and more online firms are offering investors an alternative – unmediated online access to global financial markets. This couldn’t have come at a more propitious time! The coverage of the 2008 financial crisis generated a general loss of confidence in bankers, brokers, investment firms and even pension funds. The result was an instant blossoming of investing platforms and associated services. And as occurs in nearly every new sector, the industry immediately attracted many players for whom financial investing was akin to gambling.
Although it would be pleasant to think that MiFID’s first aim was to battle this play ground, it wasn’t. MiFID’s purpose was to address the investment community – not the online gaming industry. Their first report aimed to end the monopoly of regular stock exchanges and lower the cost of trading, making it affordable for private investors and thus contributing to economic growth! Only then did they focus on principles of Best Execution, information disclosure and acting in the client’s best interests – protecting clients, reducing crime, increasing transparency and making markets smoother and less risky.
The writers of that first report recognized that regulated markets are a thing of the past; and therefore, those who provide the access must be stringently controlled – leading, conseuently, to MiFID-2.
But let’s go back a step…
In the past, stock exchanges were where intermediaries and investors carried out transactions. These exchanges had to be central in order to maintain market integrity, preserve the components of price formation and enable transactions. Today, networks are replacing these centralized exchanges, enabling users to interact freely. Transaction costs come down and the number of participants rises.
On the other hand, the economies of scale that dictated the unification of European markets, also resulted in the unification of currencies, regulation, and so forth. This included the consolidation of once mutualized national exchanges, which must now compete and remain financially feasible in an age of lowered commissions. It has also resulted in diversification of many exchanges into other sectors, such as online trading (eg. The LSE’s Turquoise and Millennium platforms, for example).
How can fragmentation and consolidation of financial markets coexist?
To understand European regulation in a unified economy, one must understand several aspects of MiFID. Unlike the US Regulatory framework, which is rules-based (prescribing in detail every point to be followed), the European approach is principle-based. It focuses on the outcomes a firm should deliver and allows for greater flexibility and innovation, saying – in effect: “we don’t care how – DO it!” It leaves the oversight to local regulators; but once an investment firm is regulated by the home state in which it is registered, it receives a ‘passport’ to provide services in all MiFID countries (i.e. EU signatories).
The Technological Edge
It is doubtful whether MiFID could have been possible in a pre-computerized age for several reasons. For example, one major requirement of the regulator is that clients must be categorized vis-à-vis their ‘appropriateness’ – i.e. clients are assessed on whether they have the appropriate knowledge and experience to access a service/product and trade responsibly. High levels of leverage, which translates into risk, can only be offered to the astute. Consequently, a complex database of investors is a must.
On the other side of the coin we have investment companies that are required to record certain elements of each transaction. They must prove that they are handling orders in the best interest of their clients – offering the best bids and offers; they are held accountable for their own transparency. Before the computer age such requirements would have been insurmountable.
Meanwhile, however, the same technology has threatened to exclude the average investor from the market. High frequency trading and commodity price manipulation have become the bane of financial markets. Supercomputers now scour the globe for price irregularities, then place and close trades – and all of this in milliseconds.
Another recent development that MiFID-2 addresses is ‘Dark trading’, in which institutional investors desiring to trade large blocks of equities without influencing their values conceal their volumes and prices offered. Dark Pools are now sufficiently voluminous that MiFID-2 will ban pools from handling an asset if its trading in that asset exceeds an as-yet-to-be defined cap.
The Rules Monster
In the interim between MiFID-1 and 2, online retail trading had taken off, landed and was ready for the second leg of its journey. The migration from gambling to investing had begun. Brokers who spored from the gaming industry were realizing that the investment sector is larger (200 times larger to be precise). As a result, the more astute have been scrambling to join the ‘legitimate’ investment community. To assist them in making the transition and to address the developing technologies in the investment world, MiFID-2 was set in motion.
We have already mentioned the auspicious timing of MiFID-1 on the eve of the global financial meltdown. And yet, even its visionaries could not have predicted the scope of market irregularities that came to light within the year. Clearly, the launch of a follow-up was immediately required.
On January 3rd 2018, eight years in the making nearly and a decade after the great collapse, the EU will introduce a set of over 1.4 million rules and reforms based on MiFID-2 – a framework for trading, clearing and reporting trillions of euros-worth of shares, bonds, commodities and derivatives through traditional and online channels of investment.
MiFID-2 offers greater protection and transparency. It embraces ETFs, Forex and everything from equities to fixed income bonds. It addresses the latest technological developments. And it takes extra care to address off-exchange markets, including derivatives, such as CFDs, Forex and options: if it’s listed and being traded within the European Union – it falls under MiFID-2 jurisdiction, no matter where the manager of the asset is located.
Continuing the tradition set out by MiFID-1, MiFID-2 favors online investing, since online transactions leave an easier-to-follow trail that can be audited. Institutions must report, for each trade, mountains of information (65 fields for each trade – much of it in real time). These can now be easily monitored for irregularities – thus preventing market abuse by investors and brokers; and that information must be stored for at least 5 years.
Keeping the channel transparent
Although focusing primarily on the irregularities of the bricks-&-mortar financial establishments, the authors of MiFID-2 are well aware of the potential and the drawbacks of online investment. Still, the desire to shift financial trading online persists. For them, MiFID-2 is:
“…a way to reduce imbalances and to level the playing field… to restore investors’ confidence (and it therefore must have) high political visibility as one of the major responses to the recent financial crisis.”
Anyone with more than one online trading account knows that brokers are judged on their spreads and transparency. A client needs to know that spreads are not exorbitant, that the prices quoted on the platform are as close as possible to the prices quoted at source, and that the broker through which he/she is placing trades is financially secure. MiFID-2 recognizes the importance of these as – quite simply – a facilitator of trade: the more confident investors are in their tools and agents, the more they will trade. Greater transparency means smoother and livelier markets, and online trading facilitates greater transparency.
MiFID addresses a wide range of topics, from market structure to platforms and beyond. It addresses investment services – the organization of investment companies so that they will be viable, and their required code of conduct, so that investors will be protected. The regulation introduces a paternalistic approach to the investor-broker relationship, creating ‘good faith’ and ‘best execution’ clauses that monitor the broker and assist the investor in (1) assessing the quality of the service he/she is receiving and (2) evaluating the profit-risk factor in each investment.
Perhaps one of the most jarring stories to emerge during the 2008-9 financial crisis was a report that one of the world’s largest investment banks – Goldman Sachs – had been investing against its clients. Clearly, when an agent is acting on behalf of another, conflicts of interest may arise. In the case of the judiciary, lawyers and judges are compelled to excuse themselves from a case.
MiFID-1 required that regulators analyze transactions of information and positions, even though these are often difficult to measure. To begin with, it published a clear set of guidelines, policies and mechanisms to be enacted. Unfortunately, much of this was also left to the discretion of local (state-based) regulators. Systems of sanctions are also fragmented – shortcomings that MiFID-2 hopes to address.
Regarding the small print, MiFID-2 will introduce a new concept: the ‘duty to disclose and behave’ on the part of the broker, rather than the ‘duty to know’, which has usually been considered to be the responsibility of the investor. Taking its cue from Common Law countries, MiFID determines that the provider must act ‘in the client’s best interest’; it also requires that ‘all information, including marketing communications’ from the broker addressed to a client or potential client be fair, clear and not misleading. By leaving this definition open to interpretation, it leaves the onus of decision up to a presiding judge, forcing the provider to expect the worst and to thus act in a manner that is ‘more Catholic than the Pope’, as it were.
Another conception that MiFID tries to battle is the belief that all regulation – especially European Union regulation – must be staid and inflexible. And regulating a sector as dynamic as financial markets always runs the risk of suffocating what must – by nature – be in constant flux. Taking the adventure out of financial trading indeed leaves us with the image of the suit-clad, tie-constricted accountant; and no stock-market baron wishes to be mistaken for one of ‘those’.
Alongside the rest of their obligations, brokers must therefore categorize their clients, offering different levels of protection based on experience, objectives and ability. MiFID-1 already requires that inexperienced traders (‘retail’) be provided with much lower levels of leverage, for example, than more experienced market pros (‘professional’). To get that 500:1 level, investors must pass 2 examinations: one that assesses his/her knowledge and the other, an experience based ‘appropriateness’ test.
Proposals under MiFID-2 include limiting eligible counterparties to non-complex trading instruments, not presuming that professionals are necessarily experts, cultural/behavioral responses to tests, and so forth. However, even the writers of MiFID-2 know that Appropriateness and Suitability procedures can be an unprecise art at best:
“The introduction into the regulation of very specific requirements to assess risk profile and suitability may become a ‘mythical search’ for a risk-free solution for consumers. The last pioneers who left for this search never returned…”
and the conclusion goes so far as to admit that, “Regulation should not decide the level of risk investors want to take.”
The narrow border between information and advice
Another interesting aspect of MiFID is the separation of investment services and information: a broker cannot advise an investor what to invest in, since the broker may have ulterior motives unrelated (and often contradictory) to the well-being of his client. MiFID-1 simply categorized investment advice – formerly an ancillary service – as a core service which must comply with a set of specifically laid-out rules of its own. A broker could acquire (for an additional €500) a license to provide investment advice, as well. MiFID-2 requires the total separation of these services.
Realizing that the uneducated investor relies upon his broker/account manager or broker-supplied news to an often unhealthy extent, MiFID-2 separates the act of ‘trading’ from ‘information-gathering’ (unbundling). To prevent a conflict of interest, asset managers must now pay for the information upon which they base their decisions. Now, research must be done by registered investment advisers – a problem in the US, for example, where this safeguard has not been adopted.
MiFID-2 suggests the introduction of a standardized advisor certificate and detailed disclosure by the provider of his/her sources of income. By being transparent, the writers also believe that investors would be more prone towards trusting the information and acting upon it.
MiFID – Aftershocks
One of the greatest achievements of MiFID has been without doubt the return of trust. By 2010, trading volumes had returned to pre-2008 levels. Markets are today less centralized and more fragmented, with greater competition benefiting the end-client: spreads are smaller and execution is quicker. Investments in trading technologies and platforms (‘fintech’) have been rising exponentially.
On the other hand, the European Union – the umbrella beneath which MiFID is organized – traditionally limits its own authority. Many of MiFID’s regulations are recommendations. In effect, it says: “if you want to get our ‘passport’ to operate in all EU countries, you must abide by these rules. If you don’t – that’s fine, too…”
The result is that the burden of responsibility continues to lie with the investor: it is he/she who must investigate the company he/she is dealing with and determine how safe that company is. MiFID provides the tools; it is up to the investor to use them.
 The result has been a consolidation of national stock markets, including examples such as the creation of Euronext by the Belgian, Dutch and French exchanges, and its merger with the New York Stock Exchange, the merger of the London Stock Exchange with the Italian Bourse, on one hand, and its failed merger with the Deutsche Bourse, on the other, and so forth.
 In fact, high-frequency trading now accounts for more than 20% of all European share trading (by value). At one point, suggestions that these be hampered by a half second delay were recognized as ludicrous; now, algorithmic traders must register their ‘algos’ with the regulator and provide circuit breakers to prevent technical glitches, such as the 2 flash crashes of 2015 that cost day-traders billions. MiFID-1 did not cover the eventualities of continuously-running algorithms that execute client orders. MiFID-2 does.
 This includes assets that are co-listed in an EU state (such as Apple) or EU-traded options for an underlying asset, which is traded in China (options on HSBC trade through a European broker, for example). None may escape: banks, institutional funds, high-frequency traders, dark-pool participants, exchanges, funds and – of course – online brokers.
 A third category – ‘eligible counterparties’ includes investment fund managers, banks, investment firms and so forth, for example. Clients may request to be treated as one category for one service and as another for another.
 The problem of market data begins at source: real-time information on prices, for example, is provided by a host of companies; however, this data is expensive. The cost of direct feeds into exchanges is prohibitive, and freely distributed post-trade data incurs a 15-minute delay. As a result, two companies rule the entire sector: Thomson-Reuters lead with 33% of the market, Bloomberg with 24%. Dow-Jones, S&P, Moody’s and 3 more leading companies account for the next 13%, and all the other data-providing companies squeeze into the remaining 21%.
MiFID-1 proposed the unbundling of such services, the eradication of the 15-minute delay, and standardization of data ‘flags’ to enable consolidating data from several sources. Unfortunately, these developments were left up to the industry…
 The British regulator, the FSA (Financial Services Authority) suggests ‘adviser charging’ for retail products – either charged for up front or taken from the investment returns. They require that advisers demonstrate their ‘fair and independent’ analysis, and would like to see non-independent advisers labelled as such. Opponents of this model claim that the sources for investment advice would go down (11% by some pollsters), prices would go up (by 9%), and people investing wildly would proliferate.