Liquidnet’s Head of Market Structure & Strategy in EMEA, Rebecca Healey, shares her thoughts—and optimism—on MiFID II.
As we head into the final hours before MiFID II implementation, there have been a number of grim scenarios predicted for January 3rd 2018. The doom-mongers may provide great head-lines but having written about MiFID for over seven years, I feel more of a palpable sense of relief that we are finally getting on with the job.
In reality, the start date may not provide much on the day itself; more likely, the delivery of a more transparent asset management industry will take time to evolve. Nevertheless, the date represents an important start in a new era in regulation, reflecting the cultural demand for greater accountability in financial services organisations. The only way to instigate real behavioural change is to make people accountable for their actions – and that is exactly what European financial regulation is intended to do. Believe it or not, there are reasons to stay positive about the future impact of regulation on European Capital Markets.
MiFID II Myth busting: Reasons to Stay Cheerful
Theory #1: MiFID will sound the death knell for research
MiFID will more likely sound the death knell for mediocre research. The difference is important. Before buy-side firms had to account for the cost of research and what they were consuming, they were faced with a wall of sell-side opacity both in terms of what research was being provided, to whom and at what cost. Now asset managers are in a position to decide what they want to consume and at what price.
Some argue that only larger asset management firms have sufficient resources to benefit from this change as they can rely more on internal research. However, changes in the production and consumption of research have been underway for some time. From research we conducted back in May 20161 it was clear then that firms were already embracing change in how research was consumed, tracked and evaluated. Of the firms interviewed, 66% valued broker research either to a small degree or not at all and 69% believed that the best quality recommendations in small and mid-cap now came from local and regional specialists as opposed to bulge bracket coverage.
It could be that larger asset managers benefit initially from the changes that MiFID brings, but changes in the consumption of research are required for all firms, irrespective of the size. As the amount of available data increases, the ability of humans to process it effectively will continue to decline. Sell-side brokers who persist in providing traditional written research will find it harder to engage their client base. Eighteen months ago, already more than half the interviewees ignored more than 50% of incoming research they received from their brokers. MiFID doesn’t sound the death knell for research, rather heralds a change in the provision and consumption of research, requiring digitalisation of investment ideas.
Theory #2: The only beneficiaries will be large asset managers and smaller firms will go to the wall.
Possible but not guaranteed. There is a key word throughout European financial services regulation – “proportionality”. One of areas of focus for the regulators is to reduce the administrative burden by implementing standardised rules across Europe, boosting competition without compromising financial stability. If you are a large organisation, clearly you benefit from economies of scale. However, the larger the firm, the greater the supposed systematic risk the firm could have on the overall stability in capital markets. As such, rather than overburdening all firms, there are elements of regulation which will only be applicable to larger organisations.
On December 20th the European Commission released proposals for simpler and less onerous rules to ensure firms “can remain commercially-viable2”. For any firm with assets over €30 billion, which carries out bank-like activities such as underwriting and dealing on own account, should now be treated as systemically important and as such “fully subject to the same treatment as
banks3” This will also be under direct supervision of the ECB rather than individual national competent authorities.
Size clearly matters in an increasingly competitive industry and consolidation will continue in active management, however this is not only due to regulation but the growing domination of passive funds. Assuming that only larger asset managers will survive is missing the point. The very firms that are in the sights of the regulators are the large global asset management firms.
Theory #3: MiFID II will halt dark trading, damaging the ability to achieve best execution.
Dark trading has been a key focus for the regulators in their attempts to get more trading back on “lit” exchanges to improve price formation. MiFID II marks the end of the buy side’s ability to use broker internal crossing networks to trade in the dark, as well as the introduction of volume caps (DVC) to be imposed on dark trading on venues. However, analysis based on adjusted trading volumes indicates that the impact may be less severe than some previous industry predictions.
Not all instruments, nor all markets have the same proportion of dark versus lit trading, but if market participants were to adjust trading behaviours either by trading in bigger blocks, or switching to lit venues or even grey order types, there is a possibility that the DVC threshold triggers can be avoided. On average, if below-LIS dark activity reduced by 21.17%, all 51% of stocks currently predicted to be capped would in fact fall below the 8% threshold4. Dark trading will not stop, nor will it flip back to the lit. It will shift shape into execution constructs that are more complex and dynamic, requiring alternative skill-sets and greater technology to navigate successfully.
Theory #4: Systematic Internalisers will be the biggest winners of MiFID II
Despite the proposed change in the make-up of dark liquidity, the buy side’s reason for trading in the dark remains firmly tied to the need to access liquidity with reduced market impact. But firms are also cutting legacy trading counterparties and concentrating broking activity with a core number of brokers. For sell-side brokers to keep a seat at the table, successful interaction with SIs as the most likely replacement for the BCNs, will be essential.
However, not all Sis will be successful. There is a trade-off between providing greater information to receive tighter pricing and incurring signalling risk and impact cost. With the increased focus on evidencing best execution, the requirement for deeper knowledge of trading outcomes is likely to continue to support a shift in dark trading patterns towards more transparent offerings. It will be the venues which provide the buy side with greater control over how, where, and when to trade in the dark, which in turn enhances the level of comfort firms have in accessing dark pools, not necessarily just SIs.
Theory #5: MiFID II puts European firms at a disadvantage
Having recently attended a summit in the US of 80+ US asset managers, it is clear that change in the industry is not only being driven by regulators but also by end investor demand. While these US asset managers have no obligation to become MiFID compliant, they are realising that to meet client demand, they do need to become MiFID-aligned.
Whether you are looking at MiFID II, CSDR, GDPR or even the senior managers’ regime, the increased use and accuracy of data imposed by regulation will ultimately lead to more efficient and well-functioning capital markets. Will this happen overnight – no, and there will be significant hurdles as control of access to investment ideas as well as execution moves from the sell- to the buy-side, but if we are to create an asset management industry that is innovative and fit for future purpose, that is what needs to happen. Maintaining the status quo would be a poor outcome for all of us.
4 “Shape Shifting – Accessing the Dark post MiFID II”, Liquidnet Research