Jeremy Taylor, strategy owner, capital markets, at GFT, discusses what constitutes an effective MiFID II programme, and where firms should be in terms of preparing for this very significant new piece of regulation.
Implementation of MiFID II has been pushed back a year, to allow more time for firms and regulators to ready their systems. The new directive—which builds on MiFID I (2007) and fulfills the requirements of the 2009 G20 meeting, also known as the Pittsburg Meeting—has three pillars: to establish fairer, safer and more efficient markets; to create stronger investment protection; and to achieve greater market transparency.
Whereas its predecessor was focused on the equity markets, MiFID II encompasses a broad range of products including fixed income, bonds, derivatives and certain commodity types. It is the single biggest piece of regulation seen in Europe since the financial crisis. As such, it represents an enormous challenge for all market participants—especially large financial institutions, such as global investment banks, that have a lot of asset classes and businesses that will be impacted. Despite the extension, firms cannot afford to rest on their laurels.
MiFID II vs MiFID I
While MiFID II builds on MiFID I, it also introduces new trading venues, known as organized trading facilities (OTFs). To bring greater transparency and create more efficient markets, the G20 mandated that all liquid products be traded on central trading execution facilities. OTFs have been introduced alongside traditional regulated markets—exchanges like the London Stock Exchange and Eurex—and multilateral trading facilities (MTFs), which were borne out of MiFID I. A fourth option is to become a systematic internaliser, which enables firms to act as principal to their own trading activity.
MiFID I introduced MTFs as an alternative to regulated markets, and to allow a central venue for the trading of non-listed products—essentially an auto-matching quote-driven market. The OTF is designed similarly, but for the other products in addition to equities. There is also more discretion around its operation—people running OTFs can decide whether or not they want to match, or partially match trades. Since their introduction in 2007, many MTFs have come to be operated by the same owners that operate regulated markets. While those venue types have started to merge, OTFs will likely continue to be operated by some of the large banks, as well as by some new entrants into the market.
OTF or OTC Market?
Both OTF and MTF venues are designed for clearable, liquid products. Illiquid products will continue to be traded on a bilateral basis outside of the new venues introduced by MiFID II. The European Securities and Markets Authority (ESMA) has been tasked with defining what constitutes a liquid product under MiFID II. That threshold will be used to determine whether or not a particular product or instrument has to be centrally traded on an MTF, OTF or RM (regulated market), or whether it is illiquid, and can therefore fall into the OTC bilateral market.
This is a complicated—and thankless—task for the regulator, which has to analyse vast quantities of data and make various calculations to determine which products are in, and which are out. It’s also fairly dynamic—it could be that some products for a certain period are deemed to be liquid, and then as volumes and liquidity drop, they’re deemed to be illiquid, and become bilateral OTC products again. There is some controversy around this, as staying on top of changing liquidity levels represents a real challenge to regulators and market participants alike.
Tackling MiFID II
When you first read the regulation, it can seem very daunting. The best way to tackle it is to break it down into digestible sections, identify which functions and processes will be affected, then construct a programme of change around that structure. GTF has identified 27 sub-themes within the three main pillars of the regulation. Although the regulation is not finalized, the technical standards have reached a mature stage, which makes it easier to conduct an impact assessment. Once you’ve assessed the requirements, you can move into the build and execution phase, and the testing phase.
Firms must have a mechanism in place to monitor the accuracy of processes and ensure compliance on an ongoing, daily basis. This is particularly important when looking at trade and transaction reporting—if trades don’t reach the reporting repository, for whatever reason, it can result in a fine. Whatever you’re building, keep the end in mind and think about whether it is going to be sustainable, scalable, and transparent once it goes live. Can senior management, at a glance, see on day-to-day basis whether they’re fully complying with all the regulations that MiFID II brings to bear?
Plan, and Don’t Procrastinate
The recently announced implementation delay gives market participants another year to get ready for MiFID II, which must come as a relief to many, but doesn’t make the task any easier. By now, firms should have established a programme, and identified an owner of the regulation. A strong command and control is necessary to set standards and create a top-level plan for the firm. But firms also need to federate in a lot of the responsibility to the individual businesses and functional areas of the organization—they will be best placed to interpret the impact of the regulation on their particular business or function.
Upfront planning is key—planning properly now can save a lot of pain in the future. The extra year will go fast. Start the process, get resources in, and start building your program as early as you can.