Here algo again: MiFID II will require your attention in 2014
For firms who remember MiFID I, and those that don’t, round two is almost upon us. This month, the Council of the EU agreed their general approach, meaning that the draft of MiFID II/MiFIR is free to advance to the European Parliament. If all goes according to the current plan, the new combined legislation will be with us in time for 2015 implementation.
Firms who invested heavily in MiFID I will be pleased to know that the structure and the main drivers remain the same. In summary, what is expected of firms is: better management and controls, safer trades, a better understanding of customers and products and greater market transparency.
To elaborate, under MiFID, firms are already subject to a number of requirements: Firstly, they are required to manage down operational risks within their own firms, such as from conflicts of interest and third party failure. Secondly, firms must ensure they are handling client orders in a timely and effective manner that maximises the benefit to their clients. Thirdly, they must protect their customers by dividing them into retail clients, professional clients and eligible investors and then treating them accordingly. And, finally, most of this must be documented and reported, either to regulators or to clients.
- Work has already begun on technical standards showing hope for a quick passage through the Parliament
- Requirements for derivatives trading have the potential to be draconian depending on future technical standards
- Firms need to think about how much OTC derivatives, dark pool and algorithmic trading they carry out
- So why the change? Under MiFID II/MiFIR some requirements have been intensified and a few new ones added. For example, client suitability reporting has been built up, with firms having to provide much greater quantities of information to retail clients. This information includes the basis of the firm’s judgement of suitability, the independence of the firm’s advice and a full breakdown of the pricing of the products the firm is offering. As a result, on-boarding processes may have to be improved and aligned.
What will be the cost of all this? Preliminary JWG research (based on experience of MiFID I) suggests that implementation will cost around £10 million for a large institution. Scaling this figure down for the 8,000 or so medium and small firms in the EU puts the total cost to the European industry at around £1.6 billion. For comparison, the cost of MiFID I to the UK alone was around £750 million, suggesting that MiFID II will be a smaller (but by no means insignificant) project.
However, the new MiFID will have a more acute impact on particular areas that are deemed to be an emerging threat to market stability, such as algorithmic trading. The requirements in their current form set out four clear expectations for algos. Firms will have to fully test their systems (prior to authorisation), and monitor them continually, to ensure that they are: i) resilient, having sufficient capacity; ii) reliable and unlikely to contribute to market volatility; iii) unable to be used for a purpose that is counter to regulation; and iv) subject to appropriate trading thresholds and limits, and prevented from sending erroneous orders. In terms of reporting, regulators may request at any time that a firm disclose any aspect of its systems’ compliance.
As currently stated, these rules are only principles and leave much room for clarification. For instance, what is the level of reliability necessary? 100% reliability? And if an algorithm goes wrong, will firms be able to rely on the fact that they fully tested the system? For answers, firms will have to look to any future technical standards. But, ultimately, best practice may be hard to find in this area due to firms’ unwillingness to share their secrets in the algo arms race.
- Will the new legislation be finalised in time to meet its current target of Q1 2015 implementation?
- How will the combined effect of MiFID II and EMIR reshape the derivatives market?
- Will systems upgrades be necessary to meet the new client classification requirements and trading requirements?
Dark pools are another high impact area. Less transparent exchanges, or organised trading facilities (OTFs) will be prevented from carrying out matched principal trading (intermediating between buyer and seller) except in instruments that typically suffer from a lack of liquidity. The list has yet to be finalised but most noticeably currently excludes equities. This will have a clear impact on the shape of the market, but from the perspective of the back office may require significant changes to firms’ order books and matching systems.
Similarly, MiFIR, reinforcing EMIR in the derivatives space, will force certain classes of derivatives to be traded on exchange. Again, firms will have to wait on technical standards to see which instruments are in this list but exchanges are already making preparations. For instance, LSE have announced the creation of a platform specifically for interest rate swaps, again having implications for firms’ trading systems.
Apart from in these three key areas – derivatives, dark pools and algos – MiFID II is unlikely to be the shock MiFID I was. For those who implemented MiFID I, the exercise is more patching up holes than it is a renaissance. However, ESMA has already begun to draft the technical standards meaning that firms have a short window in which to decide what business they do, where they do it and with whom.