MiFID II – the new transparency regime

On 1 January 2018 the latest large scale financial services regulation will go live in Europe. The Market in Financial Instruments Directive and the Market in Financial Instruments Regulation, known collectively as MiFID II, will bring in sweeping changes to the financial markets on topics such as product governance, trade reporting, commodities position limits, and transparency.

The transparency regime in particular has been subject to significant discussion and comment from market participants, professional bodies and trade associations such as the International Swaps and Derivatives Association (ISDA) and the Association for Financial Markets in Europe (AFME). It will require significant investment from investment firms for implementation, but also to run the services required. However, what is the new transparency regime, and what will it mean for investment firms and investors alike?

The transparency requirements are divided into pre–trade and post-trade to give full front to back information on the trade life cycle. The intention of the regulator is to provide investors with all the information they require in order to make an informed decision on where to trade, how to trade and who to trade with. It will also allow investigations into market abuse to be conducted on a forensic level with a plethora of market data information available.

Pre-trade transparency applies to the operators of trading venues (exchanges, multilateral trading facilities or organised trading facilities) and also to systematic internalisers. The systematic internaliser regime was first seen under MiFID I but significantly widened in product scope under MiFID II, and requires investment firms which trade on their own account when executing client orders outside a trading venue in a sufficient size to publish quotes that they are making, so the general public can view them. This can be done via a website, on an exchange or via a market data provider under an Authorised Publication Arrangement. The quotes are only executable for clients of the investment firm, however, it will allow investors using other providers to compare the prices being charged on other platforms. The quotes must be streamed firm for equity instruments and provided on a request for quotation (RFQ) basis for non-equity instruments such as bonds and derivatives. The quotes must be up to a standardised size dictated by the European Securities and Markets Authority (ESMA), for example EUR 10,000 for shares, and are therefore clearly aimed at providing retail investors with a high degree of transparency.

Consequently, it is expected that investors with multiple trading accounts will take advantage of these prices offered by systematic internalisers as well as the expanding of investment firms’ best execution desks offering order routing to the best price on either a trading venue or a third-party systematic internaliser. In addition, price competition is likely to be ever more fierce, meaning that investment firms will be constantly looking to ensure they are the best price on as many instruments as possible.

Under post-trade transparency there will be an enhancement to the MiFID I rules concerning trade reporting, and investment firms will be required to publish trade data for executions where that instrument is also traded on a venue elsewhere, thus allowing comparisons of the prices actually traded as opposed to just the quoted price. This will allow investors to compare the price that they received versus the other executions in the market on both other trading venues as well as off venue trades such as systematic internalisers.

For investment firms the real challenge lies in the time allowed for this post-trade reporting: for equity products such as ETFs it is only 1 minute whilst for derivatives it is 15 minutes. To get trades booked in this time and a report sent out will be incredibly difficult, and for voice trades even harder. In particular for smaller investment firms the challenge could result in them approaching larger banks to assist with the reporting for trades they execute with that firm. If that cannot be achieved then it will limit the number of investment firms that can be used, as smaller firms would need to ensure they would never have to report, i.e. always deal with a systematic internaliser as the reporting obligation will always be with the systematic internaliser.

Market data vendors will be able to sell both the quote and trade data they receive, but after 15 minutes it must be provided free of charge to the public; this removes one of the longstanding barriers to retail investors who had previously been put off by the high cost of market data. The question is what will investors do with the sheer amount of data that exists in the marketplace? Will investors realistically trawl through billions of quotes and millions of executions looking for best price? Might it be more likely that financial services follow other areas of life such as car insurance and see the creation of price checking websites and comparison services? Perhaps the investor can enter the ISIN of the product they are interested in, and a website will return where the best place to trade it is, as well as historic execution records. For firms that rank highly on the ‘best price league table’: expect to see reference made to this in marketing material and promotional activity.

In addition to the transparency on traded prices and quotes, MiFID II also introduces the requirement for firms to provide the client all the costs associated with a product sale. The costs have to be aggregated and broken down as a percentage of the cost of the product and should be further broken down in product costs, service costs and then also on entry costs, ongoing costs, and exit costs. These costs must be reported to the client before a trade occurs, and they must also be sent an annual summary of their costs.

As you can see, there will be significant changes to the market when MiFID II comes into force and these will require changes from both investors and investment firms. The changes in process are likely to take time for investors to get to grips with, but in the long term the transparency will provide investors with significant information and the opportunity to gain a greater understanding of the markets, both on and off trading venues. For investment firms there will be significant costs to implementing the requirements but also a great opportunity to onboard new clients and new markets. Firms that invest in new infrastructure and efficiencies will be able to offer the best possible price leading to increased flow from investors and best execution platforms. Investment firms that fail to embrace the changes will find themselves left behind and struggling to keep up as clients use the new found transparency to improve their investment strategies.