November 15, 2011

Like it or hate it, most European financial entities have a strong view of the MiFID Review. While we in the United States believe Dodd-Frank and new SEC regulations are challenging, the European sentiment on the MiFID Review makes the U.S. regulatory proposals look downright friendly.

Unlike its first iteration, MiFID II has real bite. One of the challenges with MiFID was that it was a European directive - while Brussels recommended it, the rule was implemented nationally; though some countries took MiFID seriously, some virtually ignored it. The MiFID Review places significant oversight in the hands of the European Securities & Markets Authority (ESMA), the macro securities regulator that has enforcement authority over all national European regulators.

Further, the new MiFID covers all products, not just equities. While the original MiFID was intended to be multi-asset, it was only implemented for listed products, and mostly equities.

MiFID II also tries to reduce conflicts among regulated markets (i.e., exchanges), MTFs, systematic internalizers (SI) and broker crossing networks (BCN). Under the beefed up rules, venues that internalize flow or match customer flow with in-house/proprietary capital must choose their business model - firms can become systematic internalizers and only internalize, or become an organized trading facility (OTF) and match customer flow against other customer flow.

OTFs, including broker dark pools, will not be able to match customer and owner flow, or link to other BCNs. In addition, OTFs will be subject to the same pre- and post-trade transparency regime as regulated markets and MTFs. Because SIs will not be able to match customer orders, SIs will not be able to operate an OTF or, for that matter, a BCN.

Driving Transparency

The MiFID Review also extends pre- and post-trade transparency requirements. The original MiFID effectively took a pass on mandating pre- and post-trade transparency. While the classic MiFID required SIs, MTFs and brokers to publish quotes, few brokers became SIs and many avoided quoting by building a BCN where pre-trade transparency was not an edict.

Under MiFID II, SIs will be required to publish actionable quotes, but so will OTFs (if they don't have a waiver). OTFs also will be required to provide non-discriminatory access, significantly crimping dark pools - as a quoting dark pool isn't exactly dark.

The new transparency rules also affect OTC trading, as the pre- and post-trade transparency rules cut across asset classes. This has tremendous ramifications for the trading of illiquid securities. Since all non-waivered platforms will need to provide pre- and post trade-transparency (in as close to real time as possible), information leakage will be greater and providing liquidity will become more dangerous, which will increase the cost of liquidity as well as the risk in trading less-liquid positions.

Meanwhile, though regulated markets, MTFs and OTFs will need to provide non-discriminatory access, so will clearinghouses. Under the new rules, entities running vertical clearing models will need to provide access to their clearing facilities to other non-related entities; this should open vertical exchange/clearing silos and possibly bring down the cost of trading derivatives.

The Review goes on to propose a consolidated tape, speculative curbs on derivatives trading, and rules around stricter oversight of hedge funds' use of USITS (Undertakings for Collective Investment in Transferable Securities) loopholes, as well as other major and minor rules. The bottom line of MiFID II is that it promotes aggressive transparency.

But while common sense and basic economics argue that greater transparency means more efficient markets, more competitive players and a better investor environment, I actually argue that common sense is probably wrong for all but the most liquid of assets and the smallest of investors.

Once you drop below the top names, aggressive transparency makes it more difficult to transact and more expensive to trade, harms smaller companies, and makes it more difficult to raise capital and hence, create jobs. While I am sure that the regulators went about developing the MiFID II rules with all good intentions, many of these good intentions will come back to hurt not only the industry, but investors, corporations, workers and eventually the governments that backed these rules.

ABOUT THE AUTHOR
Larry Tabb is the founder and CEO of TABB Group, the financial markets' research and strategic advisory firm focused exclusively on capital markets. Founded in 2003 and based on the interview-based ...