Back in 2007 the Markets in Financial Instruments Directive was set to ignite competition in the European equity market. Fast forward four years and hindsight, plus a financial crisis, have necessitated MiFID II.

Ostensibly a scheduled review of the original directive, MiFID II has been hijacked by the demands of the Group of 20 (G20) countries to deliver transparency to the largely unregulated over-the-counter trading of derivatives, a major source of concern during the crisis.

The proposal for MiFID II, released by the European Commission on 23 October 2011, outlines a number of changes to the directive itself and a new regulation - MiFIR - that collectively are intended to help Europe's financial markets unify in an efficient and low-risk manner.

However, while trying to address some of the holes in the original directive, the EC has created some big challenges for banks and their clients to deal with, not least because the proposal is expected to see many changes before it becomes legislation.

"There is a risk that with so many unknowns, financial institutions will only want to get involved once some of these have been resolved," says Bob Fuller, director at connectivity and market data provider Fixnetix. "The problem is, the way the European legislative process works, if you get involved late, you will find the parts you want to change have already been set."

Under current proposals, standardised OTC derivatives trading will have to move onto electronic markets. Pre- and post-trade data will have to be aggregated and published on a far more frequent basis than at present, by investment firms and market operators, including brokers. The tougher regime for trading venues will mean many existing crossing networks will have to implement new systems along the lines of exchanges and multilateral trading facilities. The algorithms used for trading must be made secure and presented to regulators for inspection. All of this adds up to pressure on the technology budget of many banks.

"There is definitely spend, and return on the spend," says Tim Dodd, head of product management for SunGard's Front Arena trading system. "Where marketplaces are becoming electronic, identifying where automation can have an effect and taking advantage of electronically available liquidity does reduce your people costs."

Falling at the first hurdle

MiFID II has set out to fix the inequalities that many market participants felt had been established under MiFID which been intended to bring competition to the equity markets. By allowing the shares that were traded almost entirely on national exchanges, to be traded on other venues, producing competition and therefore lower prices, MiFID was expected to benefit all market participants, except the national exchanges who would be losing their monopolies. However the model proved overly simplistic, making the involvement of financial institutions in MiFID II absolutely critical.

The original directive used competition between venues to lower price but it did not account for any cost of aggregating market data from multiple venues trading the same security. The lack of any standardised reporting model also meant that buy-side firms found it difficult to make like-for-like comparisons of the execution quality provided by brokers.  By allowing over-the-counter trading to occur on venues, without providing a regulatory regime for them, MiFID allowed unregulated crossing networks to pop up which further obfuscated the picture of liquidity and price in the equity market; they were not subject to the same reporting requirements as multilateral trading facilities (MTF), regulated markets or systematic internalisers.

Traders were presented with a range of venues they could use, but finding liquidity became more difficult as a result.

The incumbent national exchanges found order flow moved to the low-cost MTFs and crossing networks. The exchanges felt that many of their rival venues were unfairly advantaged by their lack of regulatory supervision. Nevertheless in the ensuing competition, trading fees fell across all venues.

Although this made MiFID successful at a surface level, the overall cost of trading did not drop for everyone. Firstly, brokers were under no obligation to pass on lower trading fees. Secondly, post-trade services were not under competitive pressure and so there was no mechanism to lower costs. National exchange operators with siloed exchanges and clearing, such Eurex in Germany, Monte Titoli in Italy and the BME in Spain, could maintain favourable charges for orders processed entirely within the silo. As a directive, MiFID was subject to transposition into national regulation, creating differences in its interpretation. In Spain, the effect of a siloed exchange and this transposition combined to effectively prevent competition in trading until early 2011, as trades required a code from the incumbent BME to be cleared and settled, which trades run through alternative venues did not have.

Other gaps prevented MiFID being as effective as intended. Although brokers were obliged to provide ‘best execution' for buy-side clients, the bilateral nature of the agreements required clients to enforce them, but independent transaction cost analysis of their execution performance was hampered again by the lack of standardised post-trade data.

MiFID came into force in just as the worst financial crisis for half a century kicked off and so its review has provided a valuable regulatory platform to address systemic risks that politicians and regulators have identified in the market. In September 2009, the G20 specified a number of changes to be made to the opaque OTC derivatives market which was seen as a cause for concern after the largely unregulated trading of OTC products contributed to and exacerbated the crisis. As a result standardised OTC derivative contracts would be traded on electronic trading platforms where appropriate, and should be cleared through central counterparties by the end of 2012 with higher capital requirements imposed on those trades that were not. All OTC contracts should be reported to trade repositories.

The cure

A number of pieces of legislation are helping to resolve these issues; the Dodd-Frank Act, the European Markets and Infrastructure Regulation and CRD4 are amongst them. In Europe, MiFID II and MiFIR are designed to plug the gaps found in the securities and derivatives markets.

As a regulation, MiFIR prevents differences appearing in the transposition of the rules. It deals with defining and regulation trading venues, pre- and post-trade transparency, algorithmic trading, the rules around trading of standardised derivatives and open access between trading venues and post-trade services.

It introduces the category of organised trading facility, a catch-all term that ensures all trading venues, including broker crossing networks which are considered a sub-category of OTF, will be subject to similar levels of regulation as those imposed on multilateral trading facilities and regulated markets. For brokers operating crossing networks, who wish to continue their operation, this will require some further investment.

As Philip Morgan, partner at law firm K&L Gates points out, "If an OTF allows algorithmic trading on its system it will need to install such things as circuit breakers and a certain amount of resilience to be compliant."

A market operator that wishes to conduct proprietary trading against client orders they must now do so through by registering the venue as a systematic internaliser and remodelling it accordingly.

See-through markets

Transparency requirements currently applied to equities will be extended to the derivatives and bond markets. Trading venues of these assets must make public all bids, offers and the depth of the order book, on a continuous basis, during normal trading hours. For large-in-scale transactions or for illiquid instruments, the EC has acknowledged that this would be onerous and so waivers are allowed for in the text, depending on the market model, trading activity and liquidity profile. The local competent authorities are able to grant these, but only with approval from ESMA and with six months notice. Within SIs, quotes provided to one client must be provided to all. Investment firms are also required to make all firm quotes public, on a reasonable commercial basis.

Price, time and size of trades must be made available post-trade by both trading venues and SIs in as close to real time as is possible, with waivers possible for some orders, based on large size or order type.

"It is interesting to note that in the text there is no mention of the ability to regularly calibrate the model, or the inclusion of features like the liquidity profile and trading activity, as was mentioned in pre-trade waivers," said Ashlin Kohler, director, EMEA G10 Rates eCommerce at Citi, at a recent briefing organised by trade body the Association for Financial Markets in Europe .

"There needs to be a system under which granting of waivers can be recalibrated on a regular basis to account for changes in the market, for example volume," said James Kotsomitis, at AFME.

Post-trade transaction reports, which investment firms are responsible for, must now contain a very high level of detail, down to the trader or algorithm responsible for the trade.

To tackle the fragmented market, the EC has proposed that a consolidated tape of post-trade price data be put together, which it has left open to commercial firms to operate. The tape will publish price data for executions with identification of the trading venues on which they took place to give market participants a much clearer view of where liquidity lies within the market. The data can also be used to provide a benchmark for firms providing TCA.

In order to get data onto the consolidated tape, it must be sent by investment firms to approved publication arrangements - APAs - which the proposal envisages will clean and standardise it; however, there are concerns about the practicality of this model.

"There's no commercial imperative for APAs to exist," says Fuller. "Reuters aren't going to put it together and we aren't going to put it together. Not unless we get told that we are going to make money at it."

Algo or not to go

The proposal that algorithmic trading systems should provide quotes on "a regular and ongoing basis to ... trading venues at all times, regardless of prevailing market conditions," is clearly aimed at high-frequency traders but is worded so as to include all participants.

"This doesn't make sense in all situations," says Martin Cornish, partner at K&L Gates. "It makes the assumption that anyone using an algorithm is a market maker which seems slightly bonkers to us."

The rules on algorithmic trading also require firms to allow regulators to inspect their systems. This has drawn fire from many quarters, and SunGard's Dodd believes that the regulation on this will have to change in some way.

"I don't think anything is set in stone yet; auditing every algorithm is either impractical or just impossible and reading source code in any quantity is a lot of work," he says. "Monitoring and sampling mode of algorithms is probably the best that can be achieved. We think a practical approach will prevail."

Although the proposal appears to put pressure on the users of algorithms Valérie Ledure, senior policy officer for securities markets at the EC accepted at a recent conference in London that these provisions had drawn wide criticism and were open to change.

In fact, far from reducing algorithmic trading volumes, by moving of derivatives trading onto electronic platforms, MiFID II could increase the use of algorithms, argues Richard Tibbetts, chief technology officer of complex event processing system provider, Streambase. The regulation proposes that central counterparties and venues should have non-discriminatory access to one another which should make the post-trade market more competitive, for derivatives as well as equities, and create fungibility between products.

 "Once you can trade a derivative on multiple venues you will have competition to collect liquidity," he says. "You already see MTF Turquoise offering rebate-based structures to attract flow and liquidity providers.  Transparency leads to competition among execution venues and that causes them to encourage more participation by high-frequency trading firms, those markets makers in this more transparent environment."

The European Parliament has issued a questionnaire on the EC's MiFID II proposal that will allow firms to provide feedback. The deadline is 13 January, 2012. However for firms looking at where to spend on technology, there will be a long process warns Morgan.

"I expect finalised legislation for Q4 2012, with a possible 18 months to two years for it to come into effect," he notes. "We are now looking at a probable effective date of Q1 2015."

Nevertheless, Fuller's assertions that firms should get involved now ring true, says Gerry Cross, head of AFME's Brussels office and managing director for advocacy. "My strong sense is that we have observed the end of the beginning," he notes. "The Council of the European Union has to form its view, as does the European Parliament; there is enormous scope for discussion and for things to change. It was clear at a recent AFME conference that among regulators there are many different views on these issues. Now is the time for us and our members to be engaged in that dialogue."