September 11, 2007

The European Union's Markets in Financial Instruments Directive (MiFID) and the United States' Regulation National Market System (Reg NMS) are both scheduled to be final in the fourth quarter of 2007. While the press has focused on the provisions regarding best execution, at their core the two regulations drastically change the way the securities industry handles market data. The result will be more sources of data and greater volume of quote data from each of those sources.

Tom Price TowerGroup

Tom Price is a senior analyst in the securities and capital markets research service at TowerGroup.

Reg NMS and MiFID will change forever the way financial services firms treat data. Both require institutions and trading venues to store massive amounts of market data even as the growth of trade volume and quote data continues unabated. The vast pipes already in place to distribute data from consolidators, electronic communications networks (ECNs) and exchanges will be under tremendous pressure to keep up, as will the applications that process the data. Further, the responsibility to prove best execution will turn information storage and retrieval into a nightmare.

Reg NMS and MiFID will have divergent impacts on market data revenues, however. Reg NMS creates new sources of market data by permitting market centers and their members to distribute their own data independently with or without fees. MiFID does the opposite, in effect taking revenue away from the exchanges -- traditional and emerging E.U. trading venues now will vie to publish market data and develop new services. At the same time, there are no industry utilities for tick data storage across the global execution venues, and given the costs, liability and disparity of information, it is unlikely that a central repository will emerge soon.

TowerGroup believes that only the large multinational broker-dealers have deep enough pockets to keep building the infrastructure required to maintain market connectivity and establish connectivity with new data sources. Smaller, regional firms that have not built the requisite data infrastructure in anticipation of the regulatory initiatives will be prime candidates to outsource it.

Regulatory compliance will be an ongoing challenge as ever more reporting and quote-generating entities emerge. The new regulatory initiatives will fracture liquidity across markets and further reduce average execution size. More important, these mandates will commoditize the broker-dealers' active trading strategies. The difficulty of ensuring compliance when humans trade will drive firms to automate the trading process completely. The winner in the hunt for liquidity, then, will be whoever can process data the fastest.

Reg NMS Targets Exchanges

Two of Reg NMS' four major components -- the Order Protection Rule (OPR) and Market Data Rules and Plans (MDRP) -- will have the greatest impact on financial services institutions' market data infrastructures. OPR levels the playing field for investors by providing equal access to prices and mandating that trades be executed at the best price. Market centers will be responsible for routing trades to the venue with the best quote, a practice that gives smaller exchanges and ECNs a chance to attract order flow.

Requirements for Compliance with RegNMS Order Protection Rule and Market Data Rules and Plans by Market Segment

MDRP revises the formula for allocating revenues from market data fees. Revenues will be allocated to markets based on the value of their quotes and trades (i.e., the best prices and the largest orders) rather than only to self-regulatory organizations (SROs), such as listed exchanges.