Firms should always act in their clients’ best interests. That simple maxim lies at the heart of MIFID II, now at the heart of financial institution compliance courses, which was aimed at strengthening protection for retail investors in the cross-border European investment market that its predecessor, MiFID I, had created. MiFID II has now – finally, after a delay of a year – come into effect. The designers of the regulation have aimed at increased transparency of markets, more structured marketplaces, better and cheaper market data, faster and more logical trade execution, more ordered markets and more easily available cost information for clients. Its scope is very broad, catching dealers, brokers and advisory services, whoever provides them. Thomson Reuters officially thinks that MiFID II will have an even more pronounced impact across the landscape than its predecessor. They believe that it will affect everyone engaged in the dealing and processing of financial instruments, from business and operating models, systems and data, to data, people and processes. Really? Or will MIFID II go the way of so much other regulation, well-intentioned but defeated by problematic implementation, legal niceties and transforming technology?
First is the obvious point that a regulation is only as good as its enforcement. The standards may be very high, but until statistical information is available on compliance, we will never know. We do know that financial institutions are now confronted with thousands of pages of standards and associated reports from the European Securities Market Association. Will they ever be read, let alone all implemented. Will clients even themselves understand the standards under which firms should operate, let alone be able to detect breaches? Will not the regulators find themselves swamped by the petabytes of reported data from William Fry identify as over 15m markets that they will now be receiving? Will recorded phone conversations lead to much of benefit, given the innumerable alternative methods of communication that firms and their clients could potentially use to evade tracking?
Second, MiFID II cannot always pin down definitions and may have created numerous hostages to legal fortune. ‘Large-scale orders’, or ‘unbundling of research’. for example, may be subject to this kind of challenge, which may end up in the courts, especially as the definitions will undoubtedly vary across different markets, e.g. shares, ETFs, or commodities. The continuing squabble over whether Average Daily Turnover can adequately serve as a one-size-fits-all metric for this purpose is illustrative of the kind of problem that may well emerge. The double volume cap and waivers from pre-trade transparency in relation to a perhaps rather arbitrary system for categorising markets as liquid or otherwise are another example of a potential grey area. Similarly, for what counts as ‘small-scale’ exemptions, what an ‘equivalent OTC contract’ is, or how algorithmic control requirements will work. ‘As quickly as technologically possible’, however sensible a principle, does not sound like an easy concept to pin down in law either.
Third, the regulations themselves have been watered-down in negotiations. For example, the number of mandatory stress scenarios has been cut to two, a doubtful benefit ensuing from what will anyway only be an annual test. Real-time stress testing, perfectly possible in theory, was not even on the regulators’ radar.
Finally, as always with EU regulation in financial services, there is a risk of driving investors off-shore, just as the original MiFID drove investors to dark pools. The problem is not those firms that obtain a Legal Entity Identifier, but those who do not. The very claim to extraterritoriality implicit in MiFID II is likely to reinforce this: US brokers may not be able to supply research information to European clients unless they register as investment advisers, for instance, which they may well prove quite unwilling to do. Perhaps above all, yet more onerous KYC regulations will have the same effect. To make matters worse, as Bloomberg has already pointed out in relation to research-sharing, the overall effect may be to drive down liquidity and end up entirely counter-productive, as liquidity is one of the best guarantees of best execution. We can look forward to silence on this kind of question from the EU itself, although after Brexit there may be some actual evidence emerging from the UK after regulations start to diverge. Member states will anyway continue to hold authority over such issues as what constitutes market-making agreements or position limits on commodity derivatives, which does not bode well for regulatory convergence in an EU scarcely replete with goodwill towards the central authorities.
MiFID II has laudable objectives for the EU financial sector. But its timing could hardly be worse, and for all the reasons outlined above, the chance of it achieving all those objectives is surely slim. If there were a best interests index in which to take a speculative position, it is surely doubtful whether it would have seen much of a rise as a result of MiFID II.