In the January issue of ‘Thinking Ahead’ we take on the role of predicting what this year will hold for financial markets from a product, market and regulatory perspective. Fortunately for me, I only have to comment on one of those topics, namely the regulatory developments we expect to see in 2019, covering technological advancement as well as the effects of existing regulation. In addition, Brexit is still on the horizon, which could well have a significant impact on regulation, in particular in a no-deal scenario.
However, before we begin looking forward, let’s take a look at what has given regulatory specialists nightmares during 2018.
My last ditch letter to Father Christmas back in 2017 didn’t yield a further one-year delay to the implementation of MiFID II nor a delay in the KIDs for PRIIPs regulation. Consequently, both went live in January 2018, and MiFID II in particular has meant a fundamental change to the way that financial services firms operate. We have looked in detail at some of the main changes within that regulation over the course of the year, with the main points being the transparency regime driven by systematic internalisers, share trading obligation, as well as an expansion of the product governance regime around target markets and suitability of products.
The legislation has also changed the market infrastructure with the addition of organised trading facilities (OTF) and the increase in the number of multilateral trading facilities (MTF) as infrastructure providers scrambled to be in scope of the new share and derivative trading obligations. With almost 125 regulated markets, 200 MTFs, 75 OTFs and 160 systematic internalisers registered with the European Securites and Markets Authority, never have investors had so many options to execute trades. However, it’s worth asking whether that additional choice has generated improvements for clients.
When you talk to trading venues and systematic internalisers, the impression gained is that the full benefits will not be realised for a little while. Indeed, data quality is currently so poor that ESMA has started to ‘name and shame’ those participants not providing data as expected, either of poor quality or not at all. Once the data quality has been improved, I would expect to see more use by investors and firms alike, which hopefully will lead to benefits for all. Firms will be able to compare their offering against other firms, and investors can drive competition by taking advantage of execution choice for their orders.
Not to be forgotten: the KIDs for PRIIPS regulation also went live, an event that significantly fuelled the amount of information provided to investors. Moreover, the format of that information has been standardised, with a prescribed document being carefully set out by the regulation requiring simple language to be used. In addition, clear identifiers such as a specific risk indicator are required, ranging from 1 (least risky) to 7 (most risky) allowing a very quick identification of the main risks and benefits of a particular product. The markets have, in the main, managed the transition fairly well with KID documents being distributed through a large number of market data providers as well as on firms’ own websites. Clearly, having KIDs available on demand was a technological challenge especially for firms with a significant number of products – for example Commerzbank offers more than 250,000 securitised products that require a KID – but it was not insurmountable.
I think, when you consider the size of the task, that most people will be broadly happy with 2018. Yes, there are things that need to be improved but over 2019 I expect that to happen.
During the course of 2019 it’s likely we will see further evidence of the role that technology is playing in shaping the future of our regulatory landscape, both in creating challenges for regulators but also offering potential solutions.
We have talked extensively about cryptocurrencies over the last year, and I don’t intend to go through the topic again save to say that I think 2019 is the year we will finally see an ETF that contains cryptocurrencies listed on a major stock exchange. At this point I see further growth in that product area, perhaps away from bitcoin and into other cryptocurrency products such Ethereum, TRON, etc. The fall of bitcoin has been nothing short of massive, with a high of USD 20,000 dollars reduced to around USD 4,000 at the time of writing. As a result, it’s possible that new products will look to take advantage of some of the better performing currencies such as TRON, which is now one of the more popular.1
What I haven’t really talked about to the same degree is the technology behind these cryptocurrencies, blockchain, and the benefits to be realised from that. We have heard plenty about clearing and how the clearing universe can be revolutionised by blockchain, but as of yet that simply hasn’t happened. That is not to say that efforts are not being made; for example, ASX in Australia announced that its current CHESS clearing system will be replaced with blockchain technology. Unfortunately, that implementation has been pushed back a few months amid concerns raised about how realistic the initial go-live date was (it is now expected to go live at the end of the first quarter of 2021). A number of infrastructure providers will be watching with interest and, if it’s successful, expect a number of new replacement projects to begin work, especially if savings from the implementation can be measured in billions.
One of the other concepts of MiFID II that has seen development is the challenge of best execution and the rise of smart order routers. In the initial stages of the go-live, significant focus was put on best execution and the role that systematic internalisers would play in this. Trading venues in particular had significant concerns that smart order routers connected to systematic internalisers would take liquidity away from trading venues. There was the potential for a venue to offer very marginal price improvements that would make no difference to a client but which would mean on absolute value the smart order router would choose that execution venue. Consequently, ESMA issued a proposed change to the EU Commission that the tick size regime should apply to trading venues and systematic internalisers alike; the current rule allowed systematic internalisers to offer prices out of line with the tick size regime. The EU Commission accepted some of the proposal and stated that systematic internalisers should only offer prices in line with the tick size regime when streaming prices on shares and depository receipts under the standard market sizes. ESMA has submitted this amendment to the European Commission for approval.2 The change would mean that, above the standard market size, the systematic internalisers can price however they like. Just this month we saw a large European bank launch a new smart order service that had connected to multiple trading venues hoping to capitalise on improved execution strategies to increase both hit and fill rates.
Technology is bound to be a significant driver of regulatory change and, as a regulatory specialist, I expect it to be an interesting year with one or two curveballs bound to show up to add to the challenge.
In the US, the Commodities Futures Trading Commission has been quite active with regards to the Dodd-Frank rules, and I expect to see this continue in 2019. The decision to leave the swap dealer notional requirement at USD 8 billion shows an understanding of the investment and resources required being fully compliant with the rules, and by leaving the threshold at USD 8 billion it keeps that requirement away from the smaller firms.
In addition, the Dodd-Frank review showed some progress in 2018 with Congress voting to remove small and medium firms from some of the requirements whilst keeping in place the main framework of the regulation. The key part of the change saw the level at which enhanced requirements and monitoring are required being raised to USD 250 billion from USD 50 billion in size whilst retaining some flexibility for banks with more than USD 100 billion. Considering President Trump’s promise to ‘do a number on Dodd-Frank’, it is clear that this is likely to be just a first step. That said, while opponents are worried about a complete rollback it’s hard to see that level of change actually happening. When you consider the CFTC approach to swap dealer notional requirements and the Congress decision to raise the threshold for increased monitoring, it’s arguable that – rather than seeing changes made to the overall framework – we are far more likely to see levels raised to remove the burden for small and medium firms whilst keeping in place strict requirements for the largest firms. This is also likely to be more politically achievable rather than appearing to be relaxing regulations for banks that are systemically important and effectively ‘too big to fail’.
In Europe we will see the impact of MiFID II continue, with data being one of the key issues going forward. The reason for this is simple: MiFID II depends on the data, without which it loses a large part of its effectiveness. Moreover, when trading venues are not providing volume data or systematic internalisers are not publishing prices, then transparency is lacking and investors see only a portion of the market which can arguably be more confusing than seeing nothing at all. I expect regulators to force the issue on data further during 2019 with areas such as machine-readable publication by market data providers and data from trading venues being a particular focus. Once these areas have been brought up to standard it will have a noticeable impact on the quality of data for systematic internaliser threshold checking, share trading obligation information, as well as what is considered to be traded on a trading venue, and therefore in scope for additional reporting requirements.
The normalisation of some kind of MiFID III is also on-going, and MEP Kay Swinbourne has mentioned on a few occasions that when this legislation does finally arrive it will be on a much smaller scale. This fits in with an article I wrote in last year’s ‘Thinking Ahead’ suggesting that new regulation is more likely to follow a ‘little and often’ mentality rather than fundamental shifts to financial markets and associated infrastructure. It’s possible that a disorderly Brexit would require further regulation but that is a significant unknown and likely to be heavily discussed during any Brexit transition period, assuming of course there is in fact a deal.
Technological advancement continues to be at the forefront of changes in the regulatory arena with blockchain technology likely to continue to grow as processes and procedures take advantage of the benefits. If ASX progresses further on its CHESS replacement, then others will swiftly follow. Early adopters will seize a significant advantage both from a strategic and pricing perspective with market participants keen to reduce their infrastructure cost base to offset cost increases in areas such as regulation. This could result in a substantial shift to blockchain technology, causing more regulatory headaches for regulators and market participants alike.
Dodd-Frank and MiFID II will continue to evolve, and it will be interesting to see both the impact of the recent US midterm elections as well as Brexit in the shaping of those two regulations through 2019. I wouldn’t expect to see massive changes in MiFID II unless a no-deal Brexit comes to pass, but there will likely be some tweaking of some of the requirements like we saw with the tick size regime. It’s likely that the focus from regulators will be on stabilisation, and they are unlikely to want to deliver many large shocks to market infrastructure at such a sensitive time.
Finally, I expect to see an ETF product with cryptocurrency underlyings launch next year, albeit with very strict conditions and aimed solely at institutional investors. This will form a test of the processes and measures in place to stop manipulation and fraud. If such an ETF proves successful over a period of time, then we are likely to see other offerings. I would expect to see specific venues and providers specialising in these offerings rather than cryptocurrency ETFs becoming standard on all trading venues. The venues that choose to offer these products will have to upgrade their infrastructure and put in place additional compliance requirements, so it will become a strategic decision whether to offer them. If these offerings subsequently become mainstream products, then the benefits will be significant. If not, they could well end up looking like the Betamax video tape with a lot of investment for limited return.
2 Approval had not been given at time of writing.