After nine months of grueling negotiations, the European Council has finally achieved a breakthrough in discussions regarding the revision of the Markets in Financial Instruments Directive (MiFID). An agreement has been reached among the members of the Council, and a spokesperson for the Irish EU presidency stated before the Financial Times that the deal will be officially signed this week, bringing the long-awaited MiFID II a step closer to completion.
MiFID has been the ruling legislation for financial transactions in the European Union for several years now. It was initially designed to bring about a harmonized regulation for investment services across the European Economic Area (EEA), and introduce better consumer protection in investment services. Its most prominent aspects included a demand for more transparency, both before and after a trade is executed, client categorization as "eligible counterparties", professional clients or retail clients (who receive highest protection protection), and a requirement for the amount of information a company collects from its client before accepting an order. The Directive also introduced the so-called MiFID passport, which allows companies falling under its jurisdiction to be authorized and regulated by the country where they have a registered office, even when dealing with clients from other EU member states.
MiFID II will revise and complement the first version, addressing issues such as banks' trading activities, dark pools, and high-frequency trading (HFT), among others. But the most significant change will be the introduction of a new category, an Organized Trading Facility (OTF), which will encompass all asset classes, including Forex, bonds, equities, etc. It will also capture all currently unregulated trading venues, including "broker-crossing networks" - networks of brokers matching clients' orders with each other outside organized trading venues, which are hidden from the market There is a special provision planned for equities OTFs – two years after application, they will be subject to an evaluation to determine whether they have been harmful to the market in any way.
Some of the other proposals made by the Council include a special clause that will allow brokerages more discretion regarding trade execution, and a requirement for clearing houses to clear financial instruments “on a non-discriminatory and transparent basis regardless of the trading venue on which a transaction is executed”. Matched principal transactions also have not been overlooked. These types of transactions allow traders to trade on market exchanges and participate in over-the-counter (OTC) transactions. If the proposed version of MiFID II is accepted, matched principal trading will only be acceptable for bonds and non-standardized (off-exchange) derivatives, to the exclusion of equities.
Severe restrictions are planned for HFT and the so-called “dark pools” - trading venues off the lit markets. According to the proposals, anyone using algorithmic trading will be forced to submit their algorithms and strategies to regulators, and provide proper risk control to prevent market disruptions (as stated, in fact, by the German HFT Act
passed earlier this year). As for dark pools, the Council is pushing for a limit of no more than 4% off-the-market trading per venue, and 8% for the entire EU region as a whole.
MiFID II impact on the market
Probably the greatest impact that MiFID II could have on foreign exchange is that, as we mentioned, Forex will fall under the category of OTF and will benefit from the greater transparency and investor protection that is paramount to the Directive. Unfortunately for brokers, increased transparency also means increased costs for reporting. Opinions have also been expressed that the limitations on dark pools and HFT could seriously disrupt brokers' current workflow.
Equity trading will probably be most affected by MiFID II in its current state. European stock exchanges have argued that including equities in the OTF category would reduce investor protection, allowing preferential treatment to certain clients. It is also possible that small and medium enterprises will have trouble raising capital in the EU.
Of course, it has to be noted that, even after the proposal is officially signed by the European Council this week, it will be some time before it can become part of standard EU legislature. A “trialogue” between the Council, European Commission and European Parliament will most likely result in further amendments to MiFID II. The process is expected to be long and difficult, as the three sides of the trialogue have had many points of discord in discussions so far. For example, the European Parliament is against the inclusion of equities among OTFs, while the Commission was in fact the first to propose the new category back in October 2011. Though the MiFID II is not likely to become a law until next year the earliest (or maybe even as late as 2015), the new proposal is clearly a step in the right direction.
In any case, changes to legislature are at this point inevitable. The US has already led the way with the signing of the Dodd-Frank act and the recent introduction of Swap Execution Facility (SEF), a platform for regulated swap trading
(swap being the exchange of one asset or liability for a similar asset or liability for the purpose of shifting risk, as per official definition). I mean, it's not for nothing OTF's have now acquired the nickname “European SEF”. The best action for Europe now seems to be to try and catch up to the US, bringing its financial markets under strict control.