The Return of the MiFIDs, 2010-2012+

We had a fun meeting of the financial services club this week, looking at the implications of MiFID, the Markets in Financial Instruments Directive, and the outlook for MiFID II, or MiFID2 if you prefer.

I’ve referenced the revision of MiFID before and included a great white paper by Philippe Guillot of CA Cheuvreux for reference.

Equally, we now see more developments taking place, including investigations by CESR – the Committee of European Securities Regulators – that will conclude at the end of May, and covers 107 questions across a broad spectrum of issues:

Investor protection and intermediaries

• Telephone recording
• Execution data quality
• Instrument complexity
• Personal recommendations
• Supervision of tied agents
• Options and discretions

Equity markets

• Pre-trade regime for RM/MTFs
• Definition of Sis
• Post trade transparency regime
• Extended scope of transparency
• Regulatory framework for consolidation and cost of market data
• RM and MTF alignment and crossing networks
• Eliminating options and discretions

Transaction reporting

• New trading capacity (riskless principal)
• Counterparty and client identifiers
• User guidelines (how to fill in the reports)

There are also bigger issues, such as the post-trade clearing environment and its challenges. For some time, there has been reference to a Clearing & Settlement Directive for example, and MiFID2 is meant to address this.

It is also meant to address the fragmentation of trade reporting and the price tape.

It may also pop a whack at ‘dark pools’ and high frequency trading.

For all we know, it could even re-regulate the new electronic trading platforms – most of which are yet to wipe their face with a profit – and make them completely unworkable by introducing reporting rules and overheads that are as onerous as the ones that traditional stock exchanges have to work with.

Now, to be clear, we don’t know what’s in MiFID2 right now – we won’t really know until 2012 or after when the new regulation is drafted – but there are some pretty good guesses and so, in order to find out what those guess would be, we gathered an expert panel on star wars day (May 4th):

• Andrew Allwright, Business Manager, MiFID Solutions, Thomson Reuters
• Andrew Bowley, Head of Electronic Trading Product Management, Nomura
• Hirander Misra, CEO of Algo Technologies Ltd and former COO, Chi-X
• Philippe Guillot, Global Head of Trading and Execution, CA Cheuvreux
• Willy Van Stappen, COO, Equiduct

to debate and discuss. Here is the outline of the evening:

MiFID Wave 2 Discussion, May 4th 2010 from Chris Skinner on Vimeo.

For full access to this knowledge, join the Financial Services Club.

Meanwhile, there are some rapid fire changes ahead with key dates this year including:

April

The FSA formed a MiFID working party and trade associations, such as FIX Protocol, ISITC, FISD and RDUG all have meetings looking at the implications of MiFID 2.

May

CESR hearings on key questions and issues around MiFID2 and closure of consultation at end of month.

June

The MiFID JWG, Joint Working Group, reforms on 9th June in a meeting at Thomson Reuters.

Wow!

The MiFID JWG reforms.

Can’t wait to be there ...

Meanwhile, for those who want something substantial to read about MiFID2, Philippe of CA Cheuvreux sent me their response to CESR's call for evidence. 

Download CESR 10-142 Micro-structural issues of the European equity markets [2MB PDF]

It's well worth a read at 57 pages.

If you're wondering what is in the document before downloading, here's the executive summary on the main answers to CESR's Call for Evidence:

I. HIGH FREQUENCY TRADING (HFT)

3. What are the key drivers of HFT, and (if any) limitations to the growth of HFT?

The key drivers of HFT are all linked to the reduction of frictional costs:

• Optimal latency reduces the implementation risk;
• Market and settlement fees (optimisation of a maker/taker model);
• Tick size.

Any change in the frictional costs of the order book has a direct impact on HFT.

4. In your view, what is the impact of high frequency trading on the market?

HFT increases the number of orders and trades being carried out on the market, decreasing the average trade size (ATS). HFT increases the trading cost for almost all players, from brokers to exchanges via the increase of complexity and memory needed to trade. HFT has no positive impact on volatility.

5. What are the key benefits of HFT? Do these benefits exist for all HFT strategies?

The benefits of HFT must be weighed against the value extracted from the markets and the extra collective costs it generates. Given that high frequency traders constantly extract value from the markets, and that activity on MTFs (mainly guided by HFT) decreases when volatility increases, it appears that when the market needs liquidity most, the HFT activity does not provide it, as it provides liquidity when it is least needed (during the market outages of November 2009, no price formation process occurred on MTFs when primary markets were closed, which means that HFT cannot be considered reliable liquidity providers). There is a disproportion between the costs supported by the markets and the supposed benefits of HFT.

6. Do you consider that HFT poses a risk to markets (e.g. from an operational or systemic perspective)? In your view, are these risks adequately mitigated?

The HFT activity raises the collective costs of trading by increasing the need for technology, anti gaming and surveillance investments. There is also no reward in terms of decreased volatility. Thus far, there is no evidence of the purported benefits of the decrease in the bid-ask spread, while the implementation costs linked to market impact have risen.

9. Do you consider that additional regulation may be desirable in relation to HF trading/ traders? If so, what kind of regulation would be suitable to address which risks?

Any increase in frictional costs is a smooth way to control the expansion of HFT. Any frictional cost components can be used to achieve this aim: increased tick sizes, minimum duration of orders, avoiding co-location, increasing market surveillance procedures that will at least increase the latency of orders.

IV. FEE STRUCTURE

Large liquidity-providing orders and small liquidity-consuming orders should pay lower fees than small liquidity providing ones (as the latter blur pre-trade information) and large consuming ones (as these create market impact and uncertainty, i.e. volatility).

1. Please describe the key developments in fee structures used by trading platforms in Europe.

Most European MTFs have adopted a maker/taker fee schedule to attract liquidity. Like other changes (tick size, co-location), fee schedules have naturally been designed to attract liquidity rather than to improve the efficiency of the Price Formation Process (PFP).

2. What are the benefits of any fee structures that you are aware of?

For investors, only the net sum of the fees is relevant. As the technological investments required to access the numerous venues available are larger than the resulting reduction in fees, no immediate benefit can be associated with the maker/taker fee schedule.

3. Are there any downsides to current fee structures and the maker/taker fee structure in particular? If yes, please describe them.

Current fee structures have a great impact on the rewards of any HF trading activity. But without regulatory constraints, their evolution is guided by the fact that they can be used to attract liquidity in one a pool vs. another one.

4. What are the impacts of current fee structures on trading platforms, participants, their trading strategies and the wider market and its efficiency?

The specificities of the maker/taker fee structure can also affect the net sum paid by investors who need to buy or sell at some point, because they have a view on the fair price of an asset (and they will have to act as liquidity consumers at some point), vs. HF traders that wait for an opportunity to arise. It is the regulator’s duty to ensure that a level playing field is maintained among the various members of an exchange or an MTF, by ensuring that proprietary orders not linked to binding market-maker activities do not receive more favourable treatment than agency orders.

V. TICK SIZE

7. What principles should determine optimal tick sizes?

At present, tick size is based only on the stock price, whereas other factors such as liquidity and volatility should also be considered. Thus far, there has been no satisfactory study of optimal tick size and the constraints that tick size should place on the order book and the PFP. We urge the regulator to take measures so that tick size cannot be used as a weapon in market share battles, and to utilise it as the main lever for adjusting the order book.

The other responses are over here
on CESR's website, and it is worth reading a few of them. 

For
example, Chi-X talk about High Frequency Trading (HFT) as "a means of execution that can be applied across a range of trading strategies referring to an automated trading process generated by mathematical algorithms rather than being a strategy in itself".

I suppose they would, as all their clients strategically use their automated trading process to generate arbitrage alpha through HFT.

Similarly, in response to the question: "Do you consider that additional regulation may be desirable in relation to HF trading/
traders? If so, what kind of regulation would be suitable to address which risks?"
NYSE Euronext state that the company: "strongly feels that HFT provides value to
the market by systematically capturing the short-term alpha".

Hmmmm ... nothing like short selling alpha is there?

They go on to say: "Harmonising at European level and upgrading regulators’ surveillance systems may require
changes in how regulators are funded, with a more even distribution of the burden across all
trading platforms, be they exchanges or MTFs."

In other words, harmonise the regulators structures and funding, but don't enforce stronger regulation.

Interesting.

Finally, a former speaker at the FSClub - Anthony Hilton, City Editor at
the
Evening Standard - wrote an excellent piece last week in said publication:

Why MiFID was the right idea but wrong result

Much is written about how the monopoly of the
Stock Exchange has been broken since the implementation of the European
directive MiFID, which encouraged the arrival of electronic trading
platforms where customers can buy and sell shares more cheaply.  What
is less commented upon is that the success of the new arrivals in
grabbing market share does not mean they are making any money ...