MiFID II: The future of European trading in the balance

Earlier this year the European Union, after two and a bit years of vigorous, and sometimes difficult negotiation, reached agreement on the level 1 text of MiFID II. The legislation provides a wide ranging package of important reforms covering both retail and wholesale investment markets, with new obligations for a range of firms providing investment services.

Reasons for an FCA MiFID II Conference

Although the rules will largely come straight from the EU text, ESMA technical standards and ESMA guidance, rather than from the FCA, we want to ensure everyone understands what they will need to do. Today’s conference is the first step in that program of education.

While agreement was reached earlier this year, the obligations of MiFID II do not take effect until 2017. So, why has the FCA decided to host a conference on this topic and why now?

First, although the level 1 text is finished, the hard work is far from over. There still remains a significant exercise for ESMA to consult, and then finalise advice to the Commission on, around 95 technical standards in the next two years. In fact, many of you will know that this exercise began over the summer with the release of 800+ pages of consultation and discussion papers by ESMA. Although the first request for comments is now closed, this conference provides an opportunity to continue the key policy discussions.

Second, once these policy discussions are had and decisions are made, the task falls to the FCA to incorporate MiFID II obligations into our regulatory regime and for firms to implement the requirements. Although the rules will largely come straight from the EU text, ESMA technical standards and ESMA guidance, rather than from the FCA, we want to ensure everyone understands what they will need to do. Today’s conference is the first step in that program of education.

And third, once firms have understood what is expected of them, they must make changes within their businesses and implement MiFID II. We recognise the scale of the challenge, but I want to stress that failing to prepare will not be considered acceptable. Today’s conference gives us the opportunity to begin to talk generally about implementation issues.

We have approximately 838 days from today until implementation in 2017 (roughly 27 months or two and a bit years). Although this sounds like a long time, it is not, and there is a lot of heavy lifting that needs to be done between now and then. We expect ESMA to publish its second CP at the end of this year, and its recommendations to the European Commission, Parliament and Council in mid-2015. Publication of technical standards will follow in late in 2015 or early 2016. Only then will the FCA consult on changes to its own rules.

Now is the right time to discuss the direction of travel on the final rules, and consider the path to implementation. And I’d just like to highlight some of the options available as we move towards the detailed rules.

MiFID II

As I hope is clear by now, ESMA is in the lead on this next stage of preparing the MiFID II framework. That is not to say that the FCA does not have a role. Over the last year I have spent significant amounts of time attending Board of Supervisors meetings, and to chair ESMA groups including the Secondary Market Standing Committee and the Commodity Derivatives Task Force.

Colleagues from across the FCA have equally been heavily involved at the working level in groups, committees and task forces, to join in discussions with our EU counterparts. As a national regulator, we also have to make changes to our systems, consider how we’ll handle new responsibilities and resource ourselves to supervise new markets.

So let’s have a look at some of the changes that are taking place, the remaining policy questions and implementation challenges the FCA sees. Hopefully this will give you a flavour of the presentations and debates we will be having later in the day.

Transparency in wholesale markets

Overall, MiFID II weighs in favour of more lit, on venue, transparent trading. But important questions remain about how this is done, and in particular how to increase transparency without reducing liquidity.

I’ll start with transparency in traded markets. One of the goals of the new MiFID II text when being proposed was to consider if and how the reforms that MiFID I created for the equity markets could be exported to the non-equity markets. The desirability of greater transparency is obvious – greater information, improving price discovery and liquidity in the markets. Or so the theory goes. So, MiFID II takes a number of steps to bring this about.

It will extend transparency into two large new markets - bond trading and derivative trading, at both the pre- and post-trade stages of a transaction. There is also provision for specified derivative contracts, that hitherto have been privately negotiated with very little visibility to the market, to be mandated to trade on exchanges or similar venues, such as new Organised Trading Facilities created by this legislation. And the equity transparency regime will be extended from shares to other equity-like instruments, such as certificates, GDRs and ETFs.

We are also seeing trading being brought out of the dark and into the light, with a cap on so-called dark trading for equities, set at 8% of total trading in the EU and 4% of total trading per venue in any one stock. We know this is likely to result in a change in the trading of both large and small cap stocks, where, for example, some high-street name FTSE 250 stocks have up to 20% of the trading occurring off lit venues.

Overall, MiFID II weighs in favour of more lit, on venue, transparent trading. But important questions remain about how this is done, and in particular how to increase transparency without reducing liquidity – the granularity of application of the rules, the calibration of thresholds for large in scale, and publication delays and the definition of ‘liquid’ instruments are key components of the thinking that must now be done.

Commodity markets

In commodity derivatives, MiFID II brings a whole new regulatory regime, including pre- and post-trade transparency and commodity position reporting requirements, and a system of position limits – the details of which are all to be worked out. All of these are important to, again, help underpin efficient pricing and market integrity. But also, they will help ensure underlying fundamentals of supply and demand in physical commodity markets set the prices there, and are not distorted by financial speculations.

The methodology that ESMA chooses to set position limits will be one of the greatest challenges in this space, but we are confident that both physical and financial markets can continue to operate effectively within the new regime.

HFT and micro-structural issues

Computerised trading – both widely used algorithmic trading and more specialist high-frequency trading (HFT) – will be given enhanced scrutiny by European regulators. New rules will tackle a range of concerns about market integrity, protection of ordinary investors and prevention of market abuse - what has been referred to by the European Commission as the toughest package of messages in the world to address HFT. Key components of the regime to regulate this space include direct regulation of HFT firms, subjecting market making strategies to market making obligations, testing of algorithms before their execution and formalisation of the ESMA automated trading guidelines.

Some market structural changes will also make markets safer and fairer, such as requirements for market circuit breakers, standards on ‘tick sizes’ and synchronisation of exchange clocks to allow better monitoring, detection and prosecution of abuse. While the framework is set by level 1, we have to now develop a balanced regime that doesn’t throw our markets back into the technological dark-ages, but ensures they are fair and safe for all users in the future.

Wholesale conduct

Wholesale conduct is also a major focus of MiFID II - proposals that advance best execution obligations, and restrictions around the use of dealing commissions to purchase investment research are two significant areas.

Best execution

For achieving best execution, the Commission has made a number of provisions designed to help improve firms’ best execution policies, enhance disclosure of order routing behaviour, and enable better client scrutiny of execution quality through the provision of more standardised data. Some significant challenges remain at level 2 on developing metrics for execution quality which are appropriate for a very diverse range of financial instruments and market models in the absence of a consolidated tape.

As with other areas of MiFID, we remain conscious that more disclosure and more transparency is not a panacea – we need to get the balance right and provide market participants with data that they both want and need. We welcome a debate about the detail of the new rules and how firms might implement this in practice in our afternoon break-out session.

Dealing Commission

Let me turn now to dealing commission. MiFID II takes steps to remove the incentives on asset managers that could influence their decisions to trade, against the interest of their clients, when purchasing research from pots of money generated by that trading. We know this is a hot-button topic for some.

ESMA’s proposal, as it stands, would lead to a market in which all valuable research (for example, that which is not generic and widely distributed) must be paid for by fund managers themselves, rather than paid unseen by their clients within transaction fees. ESMA is aware of the challenge of removing such incentives which work against investors’ interests in a way which avoids unintended consequences.

As many of you will know, the FCA believes, in line with the results of our recent thematic work, that a more effective market for research and more efficient asset management sector will develop if dealing commissions are not used to fund these goods and services. Therefore, the FCA has been supportive of ESMA’s proposal.

Retail investor protection

And finally, MiFID II contains a number of provisions that learn the lessons from MiFID I and the rules implemented in different EU Member States to enhance retail investor protection. This includes revised conduct of business rules (particularly addressing inducements and suitability requirements), new requirements around product governance and disclosure of costs and charges to investors when purchasing financial instruments and services, and a number of organisational requirements (telephone taping, remuneration of staff and conflicts management).

What lies in the balance?

Obviously, there are some significant questions that must be answered. But what lies in the balance? What are the consequences of getting things wrong?

Obviously, there are some significant questions that must be answered. But what lies in the balance? What are the consequences of getting things wrong? Well, just to put some numbers around the markets we are talking about:

• Between March 2013 and March 2014, €19.2 trillion of equity market activity took place on European exchanges and MTFs.
• Among major EU country issuers of debt securities at September 2013, there were amounts outstanding totalling $25.5 trillion.
• As of the end of June 2013, there was $621.5 trillion of notional amount outstanding in global OTC derivative markets.

We want to ensure that we’ve considered the consequences of all proposals for all stakeholders – the markets, firms, trading venues and, most importantly, investors and end-users – using the best research and industry data that is available.

However, we know that some of the fundamental costs of missing the mark include impacts on the level of trading in the wholesale market, the take up and selection of suitable investment products in retail markets, levels of liquidity, volatility, and the amount of cross-border trading. All of these may have knock-on effects for the ‘real economy’ that markets ultimately serve.

It must be remembered that the reasons for these reforms are to make markets more efficient, protect investors and help ensure stability. Each should make markets more attractive for investors and those seeking to raise capital in European markets. This should yield significant benefits for the broader economy and the competitiveness of European markets.

Conclusion

There are a range of issues that still need resolving in MiFID II and now is the time for us all collectively to put our heads together to find answers.

So, in conclusion, MiFID II is a massive project both for regulators and industry. We know that across the industry, implementing MiFID II will be a major exercise and we recognise the scale of the challenge posed.

To use a metaphor, we have jumped the first hurdle by passing the primary legislation, but there is a lot more of the race to go. Although the finishing line looks to be still in the distance, 2017 will come round quickly and there is plenty of hard work to be done before we all dip at the finishing flag.

The thoughts I want to leave you with are:

• First, there are a range of issues that still need resolving in MiFID II and now is the time for us all collectively to put our heads together to find answers. It is important that stakeholders remain engaged in the policy-making process, especially given that we can expect a second large consultation from ESMA at the end of the year.
• Second, firms cannot hold back on developing their implementation plans until all the details are available. Efforts are required now, and firms must make sure they understand our expectations and are planning towards January 2017.
• And third, the FCA recognises the challenges for industry and will be on hand to help. We will do our best to explain the new requirements, what is required of you and set out our expectations clearly.

Thank you.