Risk & Compliance

Big Headache or Big Bang?

It has an awful name and a lousy image, but a new securities law introduced next week could stir up trading across Europe.
Economist StaffOctober 29, 2007

Attempts by Brussels to reform anything are not often greeted with shrieks of joy in the finance industry; the more usual reaction is either boredom or bitter complaints from those developing an unwanted intimacy with the compliance department. The reaction to a new law on financial markets, due on November 1st, has elicited more than its fair share of grumbling by the banks since negotiations began in 2004. Yet the bureaucrats seem to have got it right this time.

The law, which goes by the mind-numbing name of MiFID (the Markets in Financial Instruments Directive), in effect creates a common market for share, commodities and derivatives trading across 30 countries in Europe. Some giddy-headed observers have even described it as Europe’s “Big Bang”, a reference to the reforms that transformed London’s financial universe over two decades ago.

“Big Bang” or not, expect dramatic changes. The new rules end the monopoly (albeit a waning one) of national stock exchanges over share trading and throw open the field to newer electronic exchanges and even the big investment banks. Until now, some countries (such as Poland, the Czech Republic and Hungary) still required trading to take place over the national exchange. Others, such as Britain, have long been more liberal.

Handed an effective monopoly like the utility companies of yore, the protected exchanges took full advantage, charging everything from fat fees on membership to hefty tariffs on each trade. Even in more liberal regimes, over-the-counter trades have had to be reported to the exchanges. The exchanges charge members for the privilege of doing so and then, to add insult to injury, levy members again for access to those data in “real time”.

The new law dismantles each one of those monopolies at a stroke. First, it forces brokers to provide what it calls “best execution” for their clients. On the face of it, this sounds like inconsequential waffle, and most of the opposition from banks stems from the fact that it brings huge compliance costs.

In the long run, however, it may work in the interests of large banks and to the detriment of smaller exchanges that have the highest costs. It means traders must now execute a buy or sell order on any exchange or trading system which they feel gives the best deal for their clients, though the exact definition of this has been left deliberately imprecise. The trades, rather than being reported to a national exchange, can now simply be made public. That represents a substantial business opportunity, as well as a potential cost saving, for the banks.

In effect, MiFID simply recognises the reality of financial markets the world over—that trading is increasingly moving away from the established exchanges. Chris Pickles, of BT Global Financial Services, estimates that between 30% and 50% of share trading in Europe is already “off-exchange”. As in America, new electronic exchanges have emerged in Europe such as Chi-X, which claim to offer investors cheaper and faster trading services than the established exchanges, and which hope to flourish under MiFID.

Much of this “off-exchange” trading, however, takes place within the big investment banks themselves and among their clients. Apart from having to pay few or no fees, a big advantage of trading in these “dark pools” is that pricing and volumes can be kept opaque. Last year, seven large investment banks in London got together to launch their own electronic exchange (called Project Turquoise) which under MiFID will trade in competition with established bourses like the London Stock Exchange (LSE) and Deutsche Börse.

Under MiFID, these off-exchange markets will in effect become more regulated, because they will have to disclose more pricing information. They will also be freer to tempt business away from the traditional exchanges. This should encourage the traditional marketplaces to lower fees and increase the speed of transactions to become more attractive, which could make for leaner markets and larger trading volumes. On the other hand, it could “balkanise” trading; one of the tests of the new law’s effectiveness will be whether it adds to overall liquidity or channels it in so many directions that it evaporates.

The new rules will squeeze the traditional exchanges’ fee income (almost half of the revenues of the big European exchanges come from trading commissions). They will also reduce the money that exchanges can make from gathering and selling data on trades to dealers and brokers. The LSE, for example, obtains almost a third of its revenue from “information services”, a chunk of which will be under threat. A group of investment banks, who themselves account for a big slice of share dealing, are planning their own effort to report trade data, known as Project Boat. Data providers like Reuters and Bloomberg already report prices from the new electronic platforms on their screens.

Two researchers, Jean-Pierre Casey and Karel Lannoo of the European Capital Markets Institute, have argued that although MiFID’s burden falls heaviest at first on the banks who have had to spend fortunes upgrading their compliance and IT systems, in the long run it is the exchanges who may be most affected. Though the authors expect large exchanges to be the main source of liquidity for a good while, they reckon that “the traditional business model of established exchanges is going to be challenged as never before.”

Already, the national exchanges are taking steps to counter the threat of competition, partly because of MiFID. The LSE has joined forces with Borsa Italiana, and the exchanges of Paris, Amsterdam, Brussels and Lisbon have forged Euronext, acquired last year by the New York Stock Exchange. According to Niki Beattie of Merrill Lynch, even though the established exchanges in Europe are monopolies, at least some of the larger ones have historically been more willing than their American counterparts to invest in new technology and are probably better equipped to take on the new electronic exchanges.

In America, a similar proliferation of such upstarts since the late 1990s has actually helped the traditional exchanges. Liquidity became so dispersed that earlier this year, the Securities and Exchange Commission introduced a new set of rules, known as Reg NMS, which effectively favour the big exchanges over electronic-trading networks. The goal was to concentrate trading in just a few venues. MiFID goes in the opposite direction.

For all this, big banks are unenthusiastic. Their churlishness about MiFID is not only because of the costs, but also because of the transparency it entails. The anonymity that came with dealing off-exchange meant that pricing became part of a bank’s intellectual property. It was also easier to process large client orders out of the market spotlight. That is one reason why Europe’s banks have successfully lobbied against MiFID being applied to the bond markets. They also argue, correctly, that too much regulation can stifle innovation. But having seen the mess banks made of structured finance, which was kept fiendishly opaque in the name of financial innovation, it is clear that even a little transparency can go a long way.