Yesterday afternoon the European Union reached a deal in crafting updated rules for Markets In Financial Instruments (MIFID). While Themis only executes equity trades in the US, we wanted to provide a cursory note touching on some of the more important issues in MIFID. The themes faced by EU regulators and participants are very similar to the themes faced by our own regulators and market participants. Clearly, our clients who trade in EU markets have a thorough background and understanding of MIFID, and this note hopefully helps the rest of our clients at least understand the basics of MIFID, and the theme-parallels with our own market regulation.

MIFID Deal Background

As a quick background, trading in financial instruments in Europe occurs in a different structure/environment than it does in the US.

–          Post trade transparency is different (consolidated tape reporting – we have one in the US).

–          MIFID recognizes three types of trading venues – Regulated markets (think exchanges), multi-lateral trading facilities (MTFs – think dark pools), and systemic internalizers (SIs – think automated wholesalers who buy order flow).

–          Much more trading takes place in dark pools in the US than in Europe – although the trend in Europe is towards more dark pool trading.

The meteoric rise of high frequency trading, which has leveled off in the US, continues in overseas markets. Fund managers in Europe, noting the leakage and noise around their investment trading when their flow interacts with high speed flow, have responded by moving more and more of their trading into the dark. A recent Bloomberg article quotes Fidessa Group as noting that dark pool trading had surged 45% of late, while exchange trading had risen only 2%. The problem with that is, at some point does too much dark pool trading – which references prices on the lit exchanges – mean that the prices on the lit exchanges are less relevant; in simpler terms, does too much dark trading hinder the price discovery mechanism of markets?

Regulators in the EU are facing the same balancing act that regulators in the US are – regulating HFT to neutralize some of the damaging aspects of the practice, finding an appropriate market structure balance that protects public markets and the value of their transparency, and yet still allowing for some competitive choices in trading – dark pools – that facilitate larger transactions. The EU regulators skeptically eye how that same balancing act is handled in the US, as they see US off-exchange trading approach 40% of volume, with an average trade size that is nearly identical in public markets and dark pools (about 200 shares).

The Deal

The MIFID II agreement reached yesterday has a little something for everyone, although there are still details that need to be worked out, and as we know too well in the US, industries are created and billions made around those details.

–          Position limits on food commodities.

–          Fair access to clearing corps.

–          Internalizers must register as an MTF/OTF. Organized Trading Facilities (OTFs) will have rules that curtail their owners from using their own capital in these OTFs to execute trades.

–          Consolidated tape post-trade transparency, with the possibility of deferred reporting as appropriate.

–          Introduction of a trading obligation for liquid instruments – requirement for all algorithmic traders to be properly regulated and to provide liquidity when pursuing a market-making strategy.

–          Firms that provide sponsored access must have risk controls in place to protect against runaway algos.

–          4% cap on dark trades in a venue, with an 8% cap on dark trading in the market in general.

MIFID Issues

There are of course many issues with MIFID II.

–          Implementation is a long way off – think 2017?

–          The requirement of a consolidated tape still has no volunteers to create that tape; its creation is a long ways off, and that tape is needed in order to enforce and 4% / 8% volume caps, for example.

–          Who chose 4% / 8% volume caps and why?

–          How far will regulators go to ensure systems and controls are in place with algorithmic firms? If they demand to see source code, will that code leak out? Will they understand it? If they do not demand to see code, is the regulation toothless?

–          What loopholes will exist with regard to using bank capital to execute trades in MTFs / OTFs?

What Should I Take Out of the Initial Deal Announcement?

Trading professionals should understand that the driving force behind MIFID EU Regulation is that they have looked at the US markets, and have decided they needed to act and lay down some rules of the road, and eliminate regulation uncertainty,  lest their markets mirror ours.

Boy, matching buyer and sellers in financial instruments sure has become complex. Once upon a time it was universally thought that matching buyers and sellers in deep and diverse transparent pools of liquidity was the key to best execution and accurate pricing of assets. This is clearly not the case globally any more, and there are advantages and disadvantages associated with this change.

Mandating all trading to be done in lit markets results in too much  market impact for larger orders. Allowing too much off exchange trading results in weak price discovery for the market as a whole, although it does give the freedom of choice for large institutions to effect block liquidity. What is the litmus test for judging how well regulators craft rules that achieve a balance between these competing themes? Will the resulting global market place:

–          Have less market-impacting glitches and algos-gone-wild?

–          Have dark pools that have average trade sizes that are substantially larger than average trade sizes than those in public markets?

–          Protect less sophisticated investors, so that they do not need as a requirement a full detailed understanding of complex rules of the road?

–          Recognize conflicts of interests, and always place customer orders ahead of proprietary trading?

The devil will be in the details, and these details will take years to be worked out.