MiFID II – What The Industry Can Expect Over The Next 600 Days

By Dr. Sandra Bramhoff, Senior Vice President, Cash Market Development, Deutsche Börse AG
If you google ‘MiFID II’ more than half a million results will be returned. The amount of information that is available seems vast but the industry still awaits the publication of some of the most important details: the final Level II measures. These include 28 RTS (Regulatory Technical Standards), 8 ITS (Implementing Technical Standards) as well as Delegated and Implementing Acts. The industry is under particular pressure regarding the modifications needed for IT systems in order to comply with the forthcoming requirements. By proposing to delay the application of MiFID II by a year European legislators have acknowledged that significant system changes need further time. Brussels is feeling the pressure: National Competent Authorities (NCA’s) need nine months to transpose the requirements into national law.
Therefore, Member States and the European Parliament are considering postponing the date for transposition into national law also by one year that is to 3 July 2017. The process also envisages a period of six months between the transposition into national law and applicability itself. In order to keep the envisaged timeline, all Level 2 measures need to be published before end of September 2016 to give market participants as well as authorities sufficient time to adapt to the new technical and legal requirements. However, one would be mistaken in believing that once the Level 2 measures are released the industry will have full clarity. The “details of the details”, which are the Level III measures in form of ESMA guidelines and Q&As, are yet to be drafted and will be important to fill the remaining gaps and to contribute to a shared understanding among NCAs of how to interpret and apply the new provisions.¹ Nevertheless, it is unlikely that the final Level III measures will be published before the end of this year.
MiFID II impact
With the introduction of a trading obligation for shares, the double volume cap mechanism² and thresholds for the Systematic Internalisers (SI)³ , OTC trading in shares will almost vanish. OTC trading will only be allowed if trading is non-systematic, ad-hoc, irregular and infrequent. So where will those that traded OTC trade in future? Will the lit markets (Regulated Markets and MTFs) benefit or will the Systematic Internaliser (SI) regime experience a revival? While Regulated Markets and MTFs will have to follow a new tick size regime (which overall implies very low spread-to-tick-ratios) SIs are exempt. Hence SIs can execute all orders of a specific client at any price better than its publicly disclosed quotes. In case matched principal trading would be allowed under the roof of the SI, clarification on this is expected with the forthcoming Delegated Acts, current broker crossing networks would be able to continue (if required) to interpose between buyer and seller in such a way that they are never exposed to market risk.
Furthermore, although the quote display requirements will increase, there will only be a small quote size, i.e. for a very liquid share it would only be 10% of standard market size which is easy to fulfil. While the industry still awaits clarity with regards to final SI thresholds⁴ it remains unclear how the internal matching platform fits into the world of MiFID II. The Level I text states that investment firms that operate an internal matching platform need to authorise as a MTF.
So if the SI thresholds are not met broker crossing networks will be able to continue trading OTC as long as their trading is non-systematic, ad-hoc, irregular and infrequent and if they are not running an internal matching platform. If the Delegated Acts will provide more clarity of what an internal matching system actually is, remains open as of today.
While in future investment firms will have to trade shares either on Regulated Markets, MTFs or SIs, the trading obligation does not apply to fixed income. However under MiFID II an additional trading category, Organised Trading Facility (OTF), will be available. The OTF is meant to capture all types of organised execution which is currently not provided by existing venues. Both organisational as well as transparency requirements will apply to ensure efficient price discovery. In comparison to Regulated Markets and MTFs the OTF category provides discretion over how orders are placed and executed. While it also allows to some extent dealing on own account (other than matched principle)⁵ it is strictly forbidden that the same legal entity that operates an OTF operates a SI. Like for equities investment firms that deal on own account by executing client orders outside a trading venue have to register as a SI. With regards to the new bond transparency rules the industry might actually see a phase-in approach for the disclosure requirements of liquid, non-liquid and size specific (SSTI) instruments that were originally proposed by ESMA. ESMA has now until mid-May to revise the draft standards that were published at the end of September 2015.
The rules on open access might also change the current post-trading landscape. Trading venues will in future be required to provide access to those CCPs that wish to clear transactions on those trading venues. Liquidity might be directed to the trading venue with the most attractive Post-Trade offering. Competition will increase on all layers of the value chain, for trading, clearing and settlement.
The introduction of market maker agreements and market maker schemes will considerably change the concept of liquidity provision. While today liquidity provision takes place on a voluntary basis, investment firms that are engaged in algorithmic trading and pursue a market making strategy⁶ will in future be required to enter into an agreement and to continue making markets during stressed market conditions. Venues will be obliged to provide incentives during those stressed market conditions.⁷ Only in times of exceptional circumstances such as extreme volatility market makers will not be obliged to provide liquidity. Today trading venues generally stop the performance measurement during these times.
Although most venues in Europe already apply order-to-trade ratios (OTR) the introduction of not only a number based but also a volume based order-to-trade-ratio will be new to most. Trading firms will be required to carefully adjust their strategies if they want to avoid breaching them, as a single breach per day would mean a violation of the OTR regime.
Investment firms as well as trading venues will be required to maintain extensive records of data, especially those ones that operate a high frequency algorithmic trading technique will be impacted. The industry needs to prepare to store terabytes of data!
The requirements to report transactions to the competent authority will be widened by including those financial instruments that are admitted to trading or traded on a trading venue (i.e. Regulated Markets, MTFs, and OTFs) or where the underlying is a financial instrument, basket or index traded on a trading venue. Investment firms will also be obliged to include a wider range of data fields in those reports. Competition will increase with regards to service offerings of reporting solutions through Approved Reporting Mechanisms (ARM).
The list of additional requirements, such as synchronisation of business clocks, license requirements for high frequency trading firms, revised best execution rules, just to mention a few more, is long. Some of these have higher impact than others but eventually will require a considerable time for implementation.
In a nutshell
With more than 1000 pages of new and revised rules the industry has a lot to absorb over the next 600 days: the impact on market structure is considerable. Although the draft RTS and ITS are available and the Delegated Acts are expected to be released in a step-wise approach this quarter, the industry needs clarity in terms of final rules. The details of the details are also not yet expected before the end of this year and not to forget implementation of MiFID II into national law.
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