The Repercussion of MiFID and Reg NMS in the U.S.
During a recent presentation to a group of sales executives on the regulatory initiatives that are taking place in Europe, I was bombarded with questions on how the Markets in Financial Instruments Directive (MiFID) would affect the U.S. and what U.S. financial institutions need to do to comply. At first this seems rather simple and obvious — if firms wish to do business in Europe they will need to comply.
I had, of course, heard about the Regulation National Market System (Reg NMS) Proposal and had up to now thought that this was the U.S. version of MiFID’s best execution requirements. There are?similarities, especially in that the implementation dates seemed to be moving targets. Both are attempting to create level playing fields for investors, and both are attempting to introduce levels of transparency that have hitherto eluded the markets. Both have been going since 2004, both have needed to defer the implementation date in the past due to?market pressures, and both have two common focus areas — best execution and transaction reporting.
But there are differences. While MiFID is more ambitious, Reg NMS is more prescriptive on a number of items. Under Reg NMS, firms will need to comply with Rule 611 (intermarket price priority for displayed and accessible quotations) — the trade-through rule — and report trades in accordance with National Association of Security Dealers (NASD) guidance, whereas MiFID orders can be traded through any channel as long as it is accessible to the market. MiFID allows the?market to determine the price increments, whereas Reg NMS has minimum price quotation intervals — no subpenny pricing is allowed unless the stock is valued at less than $1.
MiFID allows market forces to determine the channels through which data is received, whereas Reg NMS requires conformance with Access Rule 610. This sets out new standards for accessing quotations in NMS stocks. It allows the use of private linkages offered by a variety of connectivity providers; it limits the fees that any trading center can charge; and it requires the establishment, maintenance and enforcement of written rules that prohibit engaging in a practice that?displays quotations that lock or cross the protected quotations of other trading centers.
MiFID extends best execution to all traded products; Reg NMS limits this to equities on a one-size-fits-all basis. Under Reg NMS internalizers do not need to publish firm quotes for stocks traded, whereas under MiFID they will have to.
Finally, inducements are not allowed under MiFID. The Committee of European Securities Regulators (CESR) issued recommendations further tightening the regulations around inducements. Apparently, inducements are, or can be, widespread under Reg NMS. Soft bundling and commissions, however, are coming under scrutiny within the Reg NMS
regime.
So what effect will this have on the markets in the U.S.?
The Firms — There will be an increased cost of governance and compliance, and a need to comply with similar but different regulations. Do firms change their procedures for their dealings with Europe or standardize on their internal U.S. dealings? Further, MiFID imposes different constraints and requirements on differing lines of business. It is thus necessary to identify the affected lines of business before working out the extent of the directives and regulations with which you need to comply.
Best Execution — Small retail firms and those classed as nonprofessional are the potential winners. There will be little or no overhead with client classification, and MiFID will afford full protection. It does, however, reduce the choice of institution with which trades can be executed. The differences between best execution under MiFID and under Reg NMS do complicate the situation, especially for firms that operate under both on either side of the Atlantic.
Client Relationships — MiFID instigates a reform of market practice — an extension of the Know Your Customer rule introduced a few years back primarily for retail clients. This complements the Treating Customers Fairly Principle proposed in July last year for implementation in March this year.
Buy Side — The buy side gains increasing influence and importance under both MiFID and Reg NMS. The
trade-through or order-protection rule gives incentive to the buy side to display limit orders under Reg NMS (those giving a specific price upon which to deal) and potentially will provide greater market liquidity. But it could frighten away firms that may not wish to display their prices, driving liquidity to alternative trading systems or multilateral trading facilities.
Sell Side — We may well see a consolidation of firms taking place due to the complexity of the regulations and the cost involved. They will be better placed, however, to target specific markets and offerings due to the resulting enhanced data models. Broker order management systems will need to be updated to conform to the requirements of best execution and the trade-through rule under Reg NMS. This will affect all direct-access trading systems and order-routing systems. This comes at a price.
Exchanges — There will be increased competition due to the push for best execution across multiple venues. There also will be the opportunity for new products and services. An example of this is a comparison of best execution venues and the need to support intermarket sweep orders — how about the creation of a best execution?venue derivative? (After all, there are weather and climate derivatives.) There will be a need to determine the orders protected?under the trade-through rule. There is very likely to be a consolidation of exchanges across Europe. This could be as soon as late 2008 or early 2009. We are already seeing the bids for the London Stock Exchange and others, such as Borsa Italiano, Euronext and Deutsche Borse.
Data — There are massive implications for the storage and retrieval of data. MiFID mandates that all data will need to be stored for a minimum of five years and be retrievable. And although regulators have not yet determined the time scales for retrieval, under current rules data needs to be retrievable for court orders within 48 hours. In addition, there is a need to be able to reconstitute the deal from inception to execution. There is a need for an enterprisewide strategy on the means available to secure, control and track all transaction and trade-related data. Under MiFID there also is a need to prove business continuity under a live working environment.
Technology— Suppliers will see increasing pressure from customers to share the cost of implementing regulatory solutions. Both regulations will affect all front-office trading systems. Solutions will need to be implemented without disrupting the daily operations. Firms are looking to lower operational risk as a result of the demands of Basel II and the need for regulatory capital to be held in reserve to account for operational risk. The first stage is the identification of operational risk. This will have a technological impact as firms are looking to their suppliers to solve their risk-identification issues.
In addition, there will be a leveraging of emerging technologies in the existing business strategies to meet the changes in the market. As a result the range and scope of new technologies is growing rapidly, and there is a move to more open and collaborative systems.
At the End of the Day?So what can we conclude from this, and in practical terms where is the common ground? On both sides of the Atlantic we are seeing a growth in the number of compliance and regulatory initiatives. On the face of it they seem to be unconnected. In the U.S. we have Sarbanes-Oxley and the Patriot Act. In Europe we have Basel II. There is Reg NMS in the States and MiFID in Europe. And further initiatives are planned on both sides of the Atlantic. But what, if anything, do all these initiatives have in common? Is there a key to unlock the mysteries of future compliance? The key is the data. All these initiatives rely on complete, accurate and clean data. Firms need to integrate their compliance, security and monitoring systems, making data rapidly available (instantaneously?) from multiple sources. To do this, some firms have spent vast amounts of money on expensive add-ons that ultimately bring more chaos and ignore the main symptom that many firms do not have sufficient robustness in their data management. True enterprisewide data management systems are the key.
