COLLABORATION IS KEY.
Sassan Danesh and Kuhan Tharmananthar* ask what MiFID II & EMIR mean for the derivatives world, and will Europe follow the US lead where voice trading and RFQ remains firm fixtures?
In the financial industry, at least, no one ever asks the question ‘what on earth do all those European regulators actually do?’ The hundreds of pages of legislation created since the credit crisis include Basel II, UCITS IV, EMIR and now MiFID II are an ample reminder of the constant stream of work produced by the regulators. The industry, whilst changing to meet the immediate market fallout from the crisis has also had to cope with change imposed upon it by those regulations. The challenge for market participants is to how best to adapt to meet the demands of investors, shareholders and regulators at the same time.
Derivatives remain an important tool for investors to isolate and hedge risk in a much more targeted manner than possible through cash products alone. However, this benefit comes at the expense of complexity and diversity of the product set. With MiFID II’s ‘non-equity instruments’ including derivatives, there is industry concern whether the regulations take sufficient account of the specific challenges regarding complexity and liquidity. There’s also the broader question of how to meet the regulatory requirements whilst minimising time, effort and costs.
One of the key objectives of MiFID II is to develop investor protection and transparency is one of the main tools being deployed to achieve this aim. The transparency principle reaches from price publication all the way to trade execution and will have a major impact in the way the OTC derivative markets function. MiFID II lays out specific transparency requirements for investment firms and trading venues. It also duplicates the idea of systematic internalisers (SI) that was applied to the equity markets by MiFID I. The SI concept will engender an important change in the derivative space – investment firms conducting business outside a venue over voice or through electronic means will now have a series of new transparency obligations placed upon them. There are various exemptions and waivers for these obligations but they involve relatively complex ‘calibration’ calculations using data that, at the moment, simply doesn’t exist.
An example that is causing significant discussion within the industry is the requirement for SIs to publish firm quotes to their clients and trade on those within certain ‘objective and non-discriminatory’ limits. Additionally, where an SI provides a voice quote on a bilateral basis to a single client, there is an obligation to make that quote available to their wider client base.
There are further pre-trade and post-trade transparency requirements that attempt to differentiate between the different trading approaches – including voice, continuous auction book trading and request-for-quote amongst others. Another high-level objective of MiFID is to promote orderly markets. This is implemented through regulatory reporting all along the price discovery and trading lifecycle in order to allow the competent authorities to monitor market behaviour for potential systemic risks and for abuse.
An example of new data the regulation requires is for investment firms to provide and maintain reference data with the competent authorities. This is a huge issue in the derivatives landscape given the lack of a standard means of classifying derivatives such as exists in the cash world through ISIN, CUSIP, CFI and other established identifier and product taxonomies.
Imagine if each trading venue and SI develops their own protocols for meeting the MiFID II pre-trade transparency requirements. The additional complexity in the market infrastructure, caused by proprietary publication and consumption of this data will result in a massive increase in both regulatory spend and ongoing technology costs within investment firms. Additionally, the ability to aggregate information across the marketplace as a whole will be hindered, creating challenges to price discovery – the exact opposite of the regulatory intent.
A standard would allow market makers and SIs to not only meet their pre-trade transparency obligations more easily across their different electronic channels, but also to allow all investment firms to consume this data more easily, thereby allowing the proper functioning of the price discovery mechanism across the European marketplace.
Even greater challenges apply for investment firms maintaining reference data. Not only is there the issue of different participants attaching a different semantic meaning to the same fields but there is also a problem with a mismatch of the data values themselves. Both of these will not only make it more challenging for investment firms but also place a greater burden on the competent authorities who, after all, want to use this reference data to monitor and assess risk in the market.
FIX has already begun work on addressing the implementation challenges of MiFID II, with the creation of six working groups composed of experts from across the market, looking across Clock Synchronisation, Reference Data, Transparency, Best Execution, Microstructure and Order Data and Record Keeping. These groups are working through the MiFID II requirements and analysing how FIX is going to meet them. Other industry bodies such as AFME are also running market-wide workshops to examine the impact of MiFID II. The industry knows that the only way the multi-dimensional requirements of MiFID II will be met is through collaboration of this kind. Indeed, recently there was further link-up between the FIX efforts and AFME to help build a consistent approach by the industry.
Coming back to the reference data issues facing the industry, market participants have known for some time that the definition and use of data both within institutions and without is more often than not fragmented and incoherent. However, these complex taxonomies are often buried deep in the electronic architecture of market participants and their idiosyncrasies pervade across institutions and, as such, are expensive to resolve. MiFID II has provided the opportunity for investment firms and vendors – the market as a whole – to begin the long process of standardising both the semantic model for data in financial markets and the values themselves.
The new regulations offer both challenges and opportunities to the market. The challenges are understood: How can transparency be achieved without further damaging liquidity? How can an industry still undergoing change from the financial crisis continue to be profitable and innovate under all the regulatory pressure? But the opportunities, when approached through standardisation and collaboration, will allow those challenges not only to be met but also to create a richer market infrastructure, based on open standards that will improve the functioning of the market for the benefit of its participants.
*Sassan Danesh is Co-Chair OTC Products Committee, Reference Data Subcommittee, FIX Trading Community, Managing Partner, Etrading Software. Kuhan Tharmananthar is Product Manager, Etrading Software.
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