01 February 2007 Features

 

A meeting of minds

Sherree DeCovny

Reg NMS and MiFID share common goals: both drive the markets towards an electronic framework. Despite the differences, firms in the US and Europe have an opportunity to learn some important lessons from their counterparts.

The US Regulation NMS and the European MiFID have different drivers behind them. After the dotcom bust, US brokers were accused of running ahead of their clients and getting better prices while individual investors took a bath. The Securities & Exchange Commission decided that regulation was needed to put a cap on greed. MiFID, on the other hand, is part and parcel of creating an efficient single European market. “In the case of MiFID, there’s a collective creation of market structure that’s going to be efficient from day one, whereas in the US we’re trying to fix something that’s broken,” says John Coulter, vice president of marketing at Vhayu Technologies in Los Gatos, California.

MiFID consisits of about 70 rules pertaining to a broad range of asset classes ranging from cash equities to fixed income products and derivatives. In this regard, it provides a common framework for multi-asset trading.

The regulation breaks the historical monopolies of the exchanges by allowing internalisation. Banks will be able to match orders on their own books instead of going into the open market as long as they make their order books public. MiFID facilitates the establishment of Multilateral Trading Facilities (MTFs), the equivalent of electronic crosssing networks in the US. And the passport rules permit shares listed on one exchange to be traded on other venues in Europe.

In addition, MiFID provides for more transparency through unbundling. Brokers will be required to itemise their fees so investors can see how much they are charged for execution, custody, research and technology. Buy-side firms will be empowered to pick and choose the services they want and therefore reduce their costs.

In contrast to Europe, the US markets are already fragmented with plenty of exchanges and ECNs competing against each other. Fees are lower and unbundling rules are already in place. Banks are permitted to internalise, but they are not required to make their order books public — and this has given rise to dark pools of liquidity.

Just because the US market is generally more liberal does not necessarily mean it is more efficient. Reg NMS’s four rules, which only pertain to US equities, are designed to rectify a few fundamental problems.

For starters, the US markets tend to be driven by prices, unlike the European markets, which are driven by orders. Nasdaq, for instance, is a market making streaming engine, not a real order execution platform. And many US exchanges are still operating in a hybrid environment where execution is at the discretion of the trading venue. A two-way price will be shown for a given stock, but that does not guarantee a fill for an investor that hits the bid or offer. The order protection rule in Reg NMS makes the markets fairer — at least in the electronic markets. Essentially, the first investor in the queue will be the first to be executed.

Market access

The access rule caps the fees an exchange, ECN or other liquidity venue can charge its members or participants. “Today it’s very discretionary,” says Frédéric Ponzo, managing director of NET2S, an international e-business, information technology and communication infrastructure consulting firm based in Paris. “You can be charged a lot of money or you can be charged a token amount depending on how pretty a face you’ve got.”

European firms hope the access rule will make it more feasible for them to obtain membership on US exchanges. Exchange membership in Europe has been open since 1992.

Regulation NMS establishes a uniform tick price across all venues. Currently, if a given share is offered at $10, an investor may be able to do the deal at $9.999 ahead of an investor showing a bid at $10. “You’ve got the ability to do very small price improvements, which actually bear no difference in the actual value of the transaction but allows somebody to cheat the system and get first execution,” says Ponzo.

Finally, Regulation NMS allows firms to pick and choose what market data they want to buy from an exchange. Today, firms can buy the entire feed from an exchange, but they cannot buy the market data for a given segment or set of stocks they are interested in. That makes access to live market data directly from the vendor very expensive, especially for buy side firms.

Best execution is a key tenet of both Reg NMS and MiFID. The concept is prescribed very specifically within Reg NMS, but that is not the case under MiFID. The European broker-dealers, exchanges and MTFs will be required to publish their execution methodology. Then it is up to the investors to decide if they want to trade with them based on the way they execute orders.

“It allows for a more holistic approach to the best execution,” says Tim O’Connell, senior manager at BearingPoint based in New York. “Whereas Reg NMS prescribes time and price, this could be time and price, of course, but also speed, likelihood [of a fill] and whether it’s internalised.”

There will be no change in the way specific order types, such as market orders, will be executed, Christopher Pullano, managing director of BearingPoint points out. “The burden of execution as per the customer’s instruction remains in the broker-dealer in both cases,” he says.

Best execution

Not surprisingly, there are significant technology challenges associated with complying with these regulations in the short term and over the long haul. In the future, an enormous amount of additional data will have to be captured and stored in a secure environment. The data needs to be clean and seamlessly integrated so firms have a complete audit trail of their trades. When the regulators come knocking, firms must be able to retrieve the data and produce reports proving they achieved best execution. “If you change a piece of data, somebody wants to see why that was changed, how it was changed and the time stamping,” says Bart Patrick, strategy manager for risk intelligence at SAS UK.

This is no easy feat for most firms. The systems in place today are designed to support trading, not to record every single step leading up to the transaction. Existing systems will have to be augmented to pull data from disparate systems, link items together and capture unstructured data such as instant messages dated prior to the transaction.

Storage is a commodity, but firms must be able to access the data quickly. If the firm is storing the data in a traditional relational database, it could take hours or days to produce the results. As a result, more firms will have to put in time series databases that can query and pull the results in a matter of seconds or minutes.

Clearly, the risk of non-compliance dictates the need for a robust electronic platform.

“One of the things that we mustn’t do in complying with these regulations is to throw the baby out with the bath water,” warns Patrick. “There are excellent systems in place at the moment, but they have certain deficiencies when it comes to meeting these regulations. Companies should be looking to augment their systems, not start from scratch.”

The large multinationals have an advantage, at least in the MiFID environment, because they have built out their market data infrastructure to a far greater extent than regional firms, adds Tom Price, senior researcher at TowerGroup in Needham, MA. Those without the infrastructure will be scrambling to look for vendor providers who can meet their needs at a reasonable cost.

Some observers claim that Regulation NMS and MiFID will lead to more convergence of the US and European markets. MiFID Americanises the European market by promoting the development of alternative trading venues and introducing more competition and transparency. On the flip side, Reg NMS will accelerate the proliferation of electronic markets, which have been the norm in Europe for about 20 years. In that regard, financial institutions have much to learn from their counterparts from across the pond.

Both the European and US regulators plan to take an aggressive stance regarding the enforcement of Regulation NMS and MiFID. But it will take time for them to understand what data they should be looking at to prove firms are in compliance and how they can perform these examinations cost-effectively. “For two years after implementation of the regs, there’s going to be a learning process on the part of the regulators and also on the part of the dealers in terms of what they expect from their examinations,” says BearingPoint’s O’Connell.

In addition, broker-dealers in the US and Europe will have to climb a steep learning curve to discover how the markets function and behave under their respective new regimes. Over time, market participants will figure out the right types of orders they should be using in specific situations. In doing so, they will find ways to grow their business and still be compliant.