11 November 2008 Features

 

Happy Birthday, MiFID

Dan Barnes

MiFID hasn't brought about the revolution in retail share dealing that it was intended to, but it is altering trading patterns and has changed the exchange landscape.

The Markets in Financial Instruments Directive was conceived by the European Commission as part of the Financial Services Action Plan, a huge initiative intended to create a pan-European financial services marketplace that will give the continent the benefits of scale seen by countries of a similar size such as the US and China.

MiFID specifically sought to reduce the cost of trading securities and increase price transparency, with a long term view to building a market across Europe similar to that seen in the US, giving companies access to funds from the public purse, and the public access to investment opportunities. A figure widely quoted - though rarely from a definitive source - was that the cost of trading in Europe was 10 times that of the US. Certainly the banks objected to the costs they were charged, not only on trading but also on price discovery, as they had to report their trades to the exchanges and pay to receive the data in return.

The plan has created competition; however there is almost no support for the belief that this will facilitate a retail equity market or that it has assisted buy side firms. Technology has allowed multi-lateral trading facilities to be created in matters of months, working on tighter margins and offering lower cost trading. But as they seek high volumes of trades they are targeting a market that already exists - that of the institutional trader. Asset managers and retail investors are unlikely to see any benefits yet. It has also failed them in creating price transparency.

There is a feeling that the directive has not been followed through in its policing. The ability to regulate a pan-European market is limited by the lack of a pan-European regulator. "You still can't trade a fully European portfolio" says David Shrimpton, head of equity market development of the London Stock Exchange. "It is not easy to get into Turkey, Greece or Spain."

Others see it as a movement  away from the US model. Paul Pickup, director of Trading Technology notes that the US recently sought to "defragment its regulatory reporting with RegNMS, to create a more universal market view. Europe seems to be splitting them all up with less transparency than ever."

MiFID, a year in, has fundamentally changed the landscape.

The way we were

With an exchange in each country and the Concentration Rule restricting trading in the country to that exchange, the cost of trading was not subject to competition. When the exchanges were demutualised and made public, they sought profit. As the cost of trading rose, so did complaints from the banks that had pushed for demutualisation.

MiFID removed the Concentration Rule, allowing competition in the trading and reporting of trade data, two key sources of income for the exchanges. The EC also added the best execution requirement, the intention of which is interpreted by the UK's FSA as asking "intermediaries to seek the best possible deals for their clients", allowing for varying factors such as cost or speed of execution to be factored in according to the client's wishes.

MiFID as a directive was brought into effect on 1 November  2007. It has created an opportunity for competition where there was monopoly. It has broken down old, established walls. Where the markets were previously autonomous hubs the landscape is now, in the words of Richard Barden, head of channel sales at Tenfore, "like a spider's web".

The directive was a long time coming - final guidance was published in May 2007 although it was originally planned for June 2006 - and the obvious impact it would have on the exchange market was clear from the outset. "The biggest effects it has had have gone relatively unnoticed," said Chris Pickles, head of marketing, investment banking, BT Global Services. "You had Euronext effectively bought by the New York Stock Exchange, OMX in Scandinavia being bought by Nasdaq, and the London Stock Exchange merging with Borsa Italiana. The creation of a large single market with a single piece of legislation made it attractive enough for exchanges from other countries to move in. These are less noticed because they happened before 1 November last year."

Police response

The financial services industry and European authorities do not have great track records in coordination and cooperation. To implement an industry-wide directive across the continent is therefore no mean feat. Although it hasn't been rolled out fully across all countries, Herbie Skeete, chief executive of Mondo Visione, which publishes the International Handbook of Stock Exchanges, says that MiFID has been tested in the most challenging environments. "Obviously there are some countries running behind but that doesn't really matter," he says. "You're looking to see how MiFID will work in the most sophisticated environment, which is the UK. If you get it right in the UK, Germany and France where you have highly developed financial marketplaces, then it can roll out in other countries."

For a project of its scale it has quite naturally had some teething problems. Pickles notes that the EC will need to show that having started the ball rolling it is able to control it. "As the recent credit crisis has shown, regulation is one thing but actually policing as investors expect to happen is another," he says.

So far the ‘police presence' has been less than impressive according to Richard Balarkas, chief executive of Instinet, "As far as I can see the European regulators have done little to enforce compliance, not only with MiFID but with earlier directives.  Why do I still meet money managers who say they cannot execute orders with a broker who does not also provide research? This makes a mockery of best execution. Have all brokers presented their clients with statements of their execution policy and reviewed it periodically as is required under MiFID? We still cannot trade into the Madrid exchange unless we have a local office, and that barrier was supposed to be removed by the first Investment Services Directive back in 1996."

This opinion is echoed across the industry, although some market participants would rather not have regulators step in. Simon Brickles, chief executive of Plus Markets, says: "Yes, there are gaps in MiFID, but I think the market can come together to plug those gaps."

Challenges so far

One of the more debated points during the development of the directive was defining best execution as a concept. "Best execution may need some further work done on it - I don't think that was properly thought out," says Skeete. "Then again, you need to see things in practice to define where you have kinks."

As Pickup points out: "The temptation for brokers to route orders to venues which give them a discounted transaction fee is great, which is in their interests rather than the clients'. This is hard to identify with many different venues, so probably happens a lot, but I am only aware of one incident in the US where the regulator has fined a broker for not getting best execution due to routing to a preferential execution venue."

A real controversy that has developed is around the subject of price formation. The removal of trade reporting to the exchanges was considered by many to be a challenge for the buy-side firms, as they would quite simply have to manage more data from many sources in order to formulate prices. And data volumes have certainly grown. Barden says that the amount of data passing down an average ‘pipe' for a trading firm has increased by 140% since January alone, "There are more venues, generating more quotes, and the automated trading systems pick up this data generating yet more quotes - it's growing exponentially." An informal group of trading venues has formed, headed by small cap exchange Plus Markets, proposing the creation of a model for a centralised source of data such as exists in the US. There, under the Consolidated Tape System, investors are able to see reported transaction prices, with the bid/offer for securities without any indication as to which market the data or trades are from.

Todd Golub, head of markets development at Nasdaq OMX, supports this: "I think MiFID is a great first step but it hasn't tackled everything. The issue of a consolidated tape - a single point of reference for market data - still needs to be addressed."

This concept is not supported by everyone. Skeete says that technology can play its part, "but you don't need a centralised marketplace. There can be more done on standardised messaging - and that is where the regulators have a lot of work to do".

Peter Randall, chief executive of Chi-X, which supplies its market data free of charge, disputes that fragmentation is leading to difficulty in price formation: "If you look at the modern investment bank, they will have traders focussing on particular sectors - a technology/telecommunications team for example. They will be looking around for the best price for, say, a BT stock, across many venues. They're already doing that. And if you look at asset managers they too are doing that. So in a way the MTFs are assisting with price formation."

Talking about the new reporting venues that cover OTC trades such as Markit Boat, Andrew Allright, business manager for Exchange Traded Instruments of Thomson Reuters, says that both cost and quality of data has led to very limited use of it for price formation. "Certainly the feeling in the UK is that the market is less transparent as a result in that area," he says. "There is more data but they don't feel comfortable relying on that data. In some respects under MiFID, the regime for publishing data isn't as onerous as it was under the LSE for UK stocks, so you can report trades later, you can delay the reporting." He says that the Financial Services Authority is taking action on this in the UK but that pricing errors are occurring, and that the obligation for investment firms to be responsible for their reporting is not currently being enforced.

The LSE's Shrimpton agrees: "There are some concerns around post-trade transparency since MiFID, which arise from the fact that trade reporting has been liberalised but the quality of reporting to new venues is not being rigorously policed yet. There is a requirement to clean up data to allow proper price formation. It's not acceptable for fund managers to  participate in trading execution but later see trade reports in the market that are late or even missed. New entrants have incentivised the market to search for the best value in trading, with liquidity proven at a new price point. To an extent, liquidity growth has arisen since the introduction of Chi-X, and we've continued to see a growth in liquidity on SETS, also facilitated through our amended trading tariff."

Fighting their corner

There have been further concerns over the application of the regulation to, and interpretation by, incumbent exchanges. Nasdaq OMX offers a routing service to other venues, through Citigroup's network. As Golub explains: "You can have a single connection to Nasdaq OMX and we will ensure that, if you do not get the best price with us, we can route it to any of the market centres that are out there - the primaries, the MTFs: we will take all of their data in and make a determination based on that and route out accordingly." The LSE has since imposed a charge upon orders that are routed through from Nasdaq OMX via Citi, stating that they have no need to extend the same privileges granted to members to rival venues, a policy that Nasdaq OMX has publically labelled ‘anti-competitive'.

Plus Markets has filed an action in the UK High Court challenging an LSE rule on its AIM small cap exchange. The issue is that the small cap stocks listed on AIM cannot be traded on other exchanges without being reported to the LSE. The submission to the court states: "This rule, which requires trades conducted on venues other than the LSE to be reported to the LSE, is unnecessary and disproportionate, representing an abuse of the LSE's dominant market position. Trading in AIM securities was not included in the provisions of MiFID. However Plus argues that given the new ethos of competition and choice in this marketplace, this rule is archaic, anti-competitive and outside the spirit of MiFID."

It goes on to explain that approximately 90 AIM companies have also elected to be dual-traded on Plus, and claims that the exchange attracts up to 50% of their combined liquidity. It has proposed to launch a new market - Plus Europe - with the Munich Stock Exchange, that would enable the trading of AIM listed stocks across Europe.

The Venues

So far, so many complaints. But new MTFs have launched, and some are already gaining market share. Liquidity is notoriously hard to shift from one venue to another so this is no mean feat. Although the share is small compared to that of the larger exchanges they have beaten many other well established institutions.

It is precisely because of their youth that they gain an advantage. The systems and technologies they have, or intend to implement, are often far cheaper, newer and more efficient than those of the incumbents. Of course they are not attempting to be exchanges - one cannot list on an MTF for example - and various comparisons that are often made, for example on costs and staffing, are incomparable. However these economic measures are not worth ignoring entirely. Randall is keen to point out that "the London Stock Exchange employs 1,100 people - we employ 27. If the markets do slow down over the next year or so, it will be easier to pay 27 people than it will 1,100 people."

This would assume that the market is willing to support the business over such a period. Chi-X is making money, but others launched in the last month or so are too young to have been tested. Shrimpton points out that the current waters will be too choppy for minnows: "New venues will have to show profit in this market - so there may be consolidation."

Looking at the charts (see page 24) for October, it is clear that the LSE, Deutsche Börse and Euronext are still the gold, silver and bronze medal winners of venues based on turnover. Markit BOAT was initially conceived to report data for its founding companies' systematic internalisation processes, however most recently it had reported ABN Amro, Citi, Credit Suisse, Deutsche Bank, Goldman Sachs, Lehman Brothers and UBS as using it for this purpose and, Lehman Brothers excepted, along with another 19 companies reporting their OTC trades via the platform.

Not surprisingly then, it is in fact a close second but as conglomerated view it cannot be said to represent a single venue. On volumes however, Chi-X has actually taken bronze from the hands of the Frankfurt-based Deutsche Börse.

Randall is not above admitting that luck was one of three important factors that have led to the success of Chi-X but the other two were more deliberate. The first was "having superior technology, with greater capacity than even that of the incumbent exchanges," he says. The other was customer frustration with the previous incumbents. "They were so expensive to deal with, they were so difficult to deal with and just by listening to the trading community we were able to design a product that they wished to buy."

He cites the inclusion of the matching algorithm within the messaging layer as a key unique selling point for Chi-X: "It means every trade has direct and immediate access to its matching engine and that speeds things up and massively increases the capacity of the platform."

At Turquoise, things are apparently also going well, although it has only just gone fully operational. "We're very pleased with the way that things have gone," says Adrian Farnham, chief operations officer. "We had a very aggressive strategy from a technology point of view, which was that we should have much lower latency than the incumbent providers and that we should have the capacity to process 25% of the pan-European blue chip market. We're fortunate in that our system is actually over-performing the targets that we set it."

Turquoise has a target of taking 5% of the blue chip market by the end of the year and Farnham says that it is on track to achieve its goals.

Technology will also be at the core of the MTF to be launched by NYSE Euronext in November 2008. In February , the exchange began a programme to develop what is billed as the Universal Trading System, replacing the four systems currently in use following the merger. UTS will be the next generation of the ARCA system, a platform that Anthony Attia, head of development on the UTS project at NYSE Euronext says is "very proven. It handled 3 billion orders and quotes on just one day last week - we want to bring it to the next level."

The network will be based on the Secure Financial Transaction Infrastructure already used in the US.  The SFTI network will be "used to provide clients with a single connectivity set to trade on all our markets and to distribute market data from all of NYSE Euronext's markets via a single channel." 

In terms of latency, the latest benchmark showed a trading engine internal latency of between 150 and 400 microseconds, according to Attia. "UTP will be used in all of our markets; for instance, it will power the pan-European MTF we are launching at the end of the year," he said.

The launch of the LSE MTF Baikal ran into trouble when the other partner behind the new venue, Lehman Brothers, collapsed in September 2008. Following the purchase of the investment bank's European operations by Nomura, a subsidiary of which is Instinet, the backer of Chi-X, some thought the project would be difficult to revive but Shrimpton says that it will go ahead, "We're in dialogue with the Nomura team and other partners that were involved from the start and we are committed to making it work, although how we now construct it from an investment point of view may need to change." He stressed that the buy-side asked them to construct the venue and that its business model was sound:  "A fund manager doesn't want to split a £10 million trade with some parts going to dark pools, some to MTFs, they want to go to a venue that acts as a market aggregator where no-one is looking at their trading position and all or part of their execution can be sensibly managed. We believe that is the Holy Grail for fund managers."

Nasdaq OMX Europe has a straightforward plan, says Golub: "Our strategy is to bring greater efficiency to the market, and we've learned from the US market place that as you reduce friction, you increase trading. Traders want to trade but it's a question of the costs involved and risks involved." Despite the imposition of the charge levied by the LSE on any orders routed from the MTF, he is confident that its model will thrive in the new environment, "When you bring surety of execution based on the technology involved you can increase trading. So I think there's going to be a movement of market share and the pie will get larger."

Lee Hodgkinson, chief executive of SWX Europe, a user-owned and governed exchange, says that he set out a strategy one year before MiFID. "Firstly, replace the trading technology to deliver greater scalability, capacity and lower latency," he said. "Secondly we reduced our prices and moved to the ‘taker-maker' model, by which placing a buy or sell order means that you pay less than the person who takes the order, so we are rewarding investors who bring liquidity."

Through this the exchange reduced prices by 15% in April and 30% in October. He also says that he transformed the culture of the exchange to one of "perpetual dissatisfaction with the status quo. It's not enough for an exchange to innovate once a year." He gives the example of SWX Europe launching Europe's first dark liquidity pool with Nyfix.

Climate change

MiFID and its children have caused something of a shakeup in the trading environment. Shrimpton says that: "We've seen growth, along with a compression of the average trade size and a greater tranching of large trades, as a result of increased liquidity provision by statistical arbitrage players. The average trade size in the first half of this financial year was around £11,500, down from around £15,900 in the same period last year."

Robert Barnes, head of market structures and equities at UBS, cites impact also in the post trade space: "We are increasingly seeing announcements of Exchanges and MTFs offering CCP choice. Experience with multiple CCPs, SIX x-clear and LCH.Clearnet, in the Swiss market shows that the concept works well functionally and in keeping tariffs competitive.  The London Stock Exchange followed this with the announcement that it too would allow SIX x-clear to join LCH.Clearnet as competitive clearing provider."  He adds, "Deutsche Börse announced similar plans to build User choice for SIX x-clear into its core German markets with likely reciprocal access to the Swiss market for Eurex Clearing.  In October 2008, NYSE Euronext's MTF announced it would offer EuroCCP with the expectation of interoperability led by User choice among SIX x-clear, LCH.Clearnet, and EMCF." He notes that the lowering of ‘frictional costs' is a positive step while the series of incumbent fee cuts following the appearance of MTFs suggests that competition is proving itself to be effective in achieving MiFID's aims. Barnes explains, "The fact that there are so many new entrants suggests that incumbent exchange, clearing and settlement fees are too high."  The lowering of frictional costs through competitive new entry and fee cuts from the more responsive incumbents is a positive step consistent with regulatory aims of MiFID and benefits towards increased liquidity, lower market impact, and ultimately improved investment performance for issuers and investors.

Skeete says that the price reductions by incumbents have not purely been the result of MTFs entering the market: "Look at people like LIBA, and that is run by the same people who run the MTFs. These were also the same banks that wanted the exchanges to become public companies. As they became public they had to make profits. That meant charging higher prices."

With new MTFs launching over the next six months, the market is still immature. Reuters' Allright believes that the market can only hold a finite number of players: "We'll expect new venues to continue launching over the short term and maybe see consolidation at the back end of next year or later." However he notes that there are varying strategies between the new players that will allow some differentiation, "There are different turfs that they may choose to fight over. The pure Blue Chip stocks is one market that Chi-X, Turquoise, BATS and to some extent Nasdaq OMX are going after. In the smaller cap markets, Plus Markets is putting up a reasonable fight against the LSE, while Burgundy will probably be launching in the smaller cap Nordic market."

At Instinet, Balarkas has a bleaker view, both for the incumbents and for the new players: "I don't believe many of the MTFs will survive. Some of those that have already started are clearly in difficulty, so I think we'll only have three, maybe four MTFs capable of standing on their own feet in a year's time."

He believes there will have to be consolidation between MTFs and exchanges. "The exchanges are so far behind in terms of technology. They are waging a war in tens or hundreds of milliseconds of latency whilst newcomers like BATS are coming in and trading at 300 microseconds and generating 95,000 events per second," he says. "I am not sure what options they have left now. They can either invest and rebuild, or go out and buy one of the smarter MTFs that have got the technology, but haven't got the business, but neither of these will come easy given their starting point and the need to offer a return to existing shareholders." BT