The cross-asset nature of MiFID II will demand significant investment from the asset management and banking communities. In this article, Dan Barnes and Mike O’Hara of The Realization Group speak to Matthew Coupe of Barclays, James Baugh and Ashlin Kohler of Citigroup, Bob Fuller of Fixnetix, Glenn Poulter of Stratevolve and Ollie Cadman of Vela Trading Technologies about how firms are addressing the various cross-asset challenges of MiFID II in order to stay both compliant and competitive.
From 3 January 2018, European capital markets will be reshaped by the new Markets in Financial Instruments Directive (MiFID II). This directive, and its sister regulation MiFIR, will significantly expand upon the existing harmonised regulatory framework for equity market trading, established in 2007 under MiFID.
Glenn Poulter, director at strategy consulting firm Stratevolve, sets the scene. “If you think about what the regulators and the central banks are trying to do, the key thing is improving the banking sector’s ability to absorb shocks from financial and economic stress. Go back to MiFID and other rules, it’s all about improving management and governance, it’s all about strengthening the bank’s balance sheets, it’s all about transparency and disclosure to the consumer. Those high level headlines are what’s really driving these markets from OTC voice-driven markets to on-exchange traded markets.”
The new framework reaches beyond the current scope of equities to capture all other cash instruments with the exception of currencies, and takes in equity, FX, rates, credit and commodity derivatives traded over-the-counter (OTC) or on a venue, all of which will also be subject to a best execution obligation. It will also impose a significant burden upon the firms trading them.
“The key thing is improving the banking sector’s ability to absorb shocks from financial and economic stress.”
Glenn Poulter, Stratevolve
In an effort to increase price transparency, thereby increasing competition and forcing prices down, MiFID II also requires greater regulatory disclosures, demanding an electronic ‘paper trail’ that can be followed to support decision-making processes.
The method of payment for investment research will also change. Investment managers will no longer be able to pay brokers through trading commissions, but will have to unbundle the payment for each service. The drive towards transparency is intended to remove barriers to competition, by giving regulators, investors, and their agents a clearer picture of cost and of decision making.
The changes represent a significant change to the sell-side commercial model. Asset managers will also take a hit as they must pay for research out of their own pocket or explicitly charge clients for it.
A key to enabling unbundled payment processes, best execution and other changes in reporting will fundamentally be enabled through the ability of firms to source and use data says Matthew Coupe, head of market structure at Barclays and Co-Chair EMEA Regulatory Subcommittee, FIX Trading Community.
“The fundamental base for any firm to be able to understand and comply with MiFID in an effective way is data. That means across all business lines, you need to understand your data and be able to put it together to understand what’s been going on, and what’s happening now.”
The need to manage data will be a major driver behind increased technology spend, as systems are delivered that can frame the trading lifecycle. Over-the-counter (OTC) trading, in which transactions are agreed directly between buyer and seller, is to be formalised via the regulation of organised and multilateral trading facilities (OTFs/MTFs).
The new OTF category is designed in wide terms to capture trading in such a way that no OTC trading can avoid the rules around access, execution and reporting.
The category of systematic internalisers (SIs), defined as “investment firms which, on an organised, frequent systematic and substantial basis, deal on own account by executing client orders outside a trading venue”, had been introduced in the 2007 regulation, however it was a definition that many dealers did not take on because the description was fairly loose. As a result they were able to trade free of many obligations imposed on other mechanisms. That status has been given a far tighter definition under MiFID II1 and OTFs and SIs are expected to capture the lion’s share of OTC trading.
The demand upon each trading firm to monitor its proportions of trading along with the requirement for recording all communication that leads to a transaction will increase the pressure to move to electronic trading. Small ticket, more liquid trades will be most easily pushed onto electronic markets.
This means that firms will need to be more nimble, according to Ollie Cadman, head of product and strategy for EMEA at Vela Trading Technologies. “The addition of more venues and venue types have the potential to increase firms’ operational overheads and consume precious technical resource. The key will be for firms to do this in a way that ensures they continue to be agile, respond to market trends and focus on delivering business benefits. As different instrument types are at different stages being electronically traded, you can’t predict with ease where momentum will be greatest, so agility will be key to remain both competitive and compliant, especially on the sell-side.”
“ Agility will be key to remain both competitive and compliant, especially on the sell-side.”
Ollie Cadman, Vela Trading Technologies
The ‘best execution’ obligation that exists for equities, intended to provide transparency around execution quality and cost, will now be applied to those instruments that fall under MiFID II, requiring substantial new data capture and retrieval capabilities to demonstrate the process.
Perhaps the most complex and substantial operational change will be for firms seeking to support these transparency objectives.
In equities, electronic trading essentially means one thing only, notes Coupe and that is generally trading on venue. Expanding on that is not straightforward for assets that are not listed.
“If you look at the non-equity space, you have a much wider set of ways for people to communicate,” he says. “That might be through Bloomberg Chat, or another messaging provider. It might be via telephone. It might be through a marketplace. The massive range of channels for transmitting pricing and information around trades creates a more complex problem under MiFID II.”
“The massive range of channels for transmitting pricing and information around trades (in non-equities) creates a more complex problem under MiFID II.”
Matthew Coupe, Barclays
Leaping data hurdles
The data will have to be captured and standardised so a regulator can put their finger on exactly what has happened and how an instrument has been traded. For OTC instruments such as bonds, that will require considerably greater data capture and storage than is currently standard market practice, necessitating automation of the process.
The amount of data captured is vastly more than is needed at present. The decision-making process around why a client order has arrived at a particular destination to trade, and whether they chose a venue, a particular dealer, or group of dealers, is not currently stored in a way that is easily accessible in five years’ time. Under MiFID II that will be a necessity.
“There’s a lot of resistance around it, because these markets really rely on speed,” says Ashlin Kohler, Director, Rates & Credit eCommerce at Citigroup.
“There’s a lot of resistance around (greater data capture and storage), because these markets really rely on speed.”
Ashlin Kohler, Citigroup
While many markets operate via voice trading – in a 2015 report Greenwich Associates estimated 50% of volume for investment grade credit trading and 57% of volume for rates in Europe was electronic – the ability to get a price quickly from as few dealers as possible limits the chance of information leakage, which can increase the cost of the trade and hurt the value of the investment.
“The discretion and immediacy element of it is key, and the resistance was around, ‘Well, now if I have to enter all these details…” says Kohler. “There are quite a few details: What it is you’re trading? What side is the client on? Are they a MiFID II counterpart? Are you going to be booking it against the MiFID II entity? What type of order is it? What’s the size?”
The identifiers for the entity and the trade take time to key in and there is little if any standardisation of data as there has been no need for it prior to these rules. International Securities Identification Numbers (ISINs) are now needed across the board, which for OTC instruments and specifically derivatives is an entirely new concept.
James Baugh, head of European Market Structure at Citigroup says, “ISINs don’t even exist for most of these products right now. You’ve got to phone up UnaVista in the UK, who are the numbering agency as part of that process, to actually generate an ISIN.”
Kohler says, “Everyone asks, ‘How am I going to get all this information into something to give me what I need quickly and as quick as voice?’”
Given the level of uncertainty, making an investment in systems is challenging. Creating a regulatory framework that will change market structure but not define it has the potential to lead firms down developmental cul-de-sacs, warns Bob Fuller, director at Fixnetix, particularly where they need to invest in the systems that will support their capacity to comply with the rules.
“Potential OTFs, systematic internalisers (SIs) and other market participants can’t agree with each other about what should happen,” he says. “There is no agreed market structure at the present point in time. But then until you can get a market structure agreed you can’t work out the flows to keep that market structure going.”
“Until you can get a market structure agreed you can’t work out the flows to keep that market structure going.”
Bob Fuller, Fixnetix
Not that market structure is fixed; there are thresholds for specific instruments that determine whether or not they can be traded on a specific venue or type of venue based upon the proportion of trading they have already conducted. Tracking this information will be enormously challenging, says Baugh.
“If ESMA are going to be the golden source of that data when are we going to get that list of products? When are we going to get that information? Because we need to be developing and building things now,” he says.
Other intended sources or reference data, such as the consolidated tape for equity price data that ESMA proposed in 2010 to defend the market against price fragmentation have not materialised six years later and lack a clear path towards development. As just such a service is mooted for fixed income, there are reasons to be doubtful about whether it will be forthcoming. “There is just no commercial incentive for any vendor to step up and be that golden source or be that alternative data provider,” says Baugh. “And you saw that with the equity consolidated tape. If you want to consolidate a tape today you can drag and drop and build it yourself. It just costs you a lot of money.”
A clearer path
With much to be done, tapping into existing change programmes can allow firms to realise some of the developments needed to manage data across the front, middle and back office so that progress can be made ahead of the detail being known. Looking at the definite effects of MiFID II – such as fragmentation – can also help to prepare firms.
Cadman says, “With the expected proliferation of trading venues it will be important to create connectivity to them as easily as possible. Having the ability to write to one application programming interface (API) to access multiple data sources and markets would be a considerable advantage.”
Firms will have to collect additional information from clients, such as personal details on the traders themselves who place orders. As the sharing of personal details can clash with privacy and data protection laws in countries both inside and outside of Europe, it will be incumbent upon firms to build a data capture and storage mechanism that does not clash with legal frameworks.
Coupe says that it is incumbent upon market structure experts to assist clients and the market more broadly in their ability to come to terms with the changes. One element of that is advocacy, looking at the regulation and engaging with the regulators to understand the impact then talking through the impact of the unknown consequences, as a practitioner.
“They might be able to adjust, to make the rules as effective as possible,” he says. “The next part of that market structure role is formulating the business strategy; how do we respond to it? How do we actually hit the compliance, and how is the business going to evolve?”
While many complex requirements sit with broker-dealers, the obligations bound to their clients on the buy side in trying to manage their own transaction reporting and best execution obligations will prove a shock for some.
Baugh says, “A significant number of firms don’t have the scale or the wherewithal to manage all of this data that they’re going to require to be compliant. It’s not just a non-equity challenge and I think, if not already, the buy side is starting to realise the challenge they are facing.”
“The buy side is starting to realise the challenge they are facing.”
James Baugh, Citigroup
The industry has made regulatory compliance a top point on its agenda, but there is also the potential for firms to look for opportunity in the process of change.
“How do we assess the opportunity and respond? Generally, that is with technology,” Coupe notes. “The final part is engaging with clients. Because if we do not engage with our clients, we can be very siloed in our thinking. Our client might have a different viewpoint.”
The industry overall is facing rising costs and falling margins, making additional spend a considerable challenge. Low rates, high volatility – or bursts of it – and macro-economic factors are taking their toll. While compliance is not optional optimising the compliance process to minimise costs such as connectivity and data use is key.
“Banks aren’t making a lot of money with interest rates so low, so they haven’t got the money to invest,” says Fuller. “Regulators are changing everything the banks do and asking them to invest money in that process, and once that is done the process is more transparent, increasing cost competition. So motivating people could be a challenge.”
MiFID II is not occurring in a vacuum. With Basel III imposing considerable restrictions upon the risk that banks can take onto their balance sheets, the relationship between buy- and sell-side firms is changing. That is pushing buy-side firms to take a more active role in making prices and driving regulatory change.
“There is a technology revolution going on across the buy side at the moment; as they grow their in-house execution expertise this is having a knock-on impact on their technology stack and causing a number of firms to refresh legacy, and potentially out of date, systems” says Cadman. “MiFID II is helping to drive that refresh but also introduces a deadline for completion of some critical parts. Firms need to be clever in their decisions to build, buy or partner. They need to ensure they are maximising their investment in areas they can differentiate and leveraging trusted partners and vendors for the rest. This is where we’re having some very interesting conversations at the moment.”