RegTech Intelligence 
JWG analysis.
By January 2017, European financial services legislation will have significantly changed the financial services sector. The sheer volume of transactions, products and firms affected by the new regulation means that we can say goodbye to the trading landscape we currently know.
In part 1 of this article, we discuss five of the 10 key changes we are expecting as a result of the ‘regulatory revolution’ … also known as MiFID II.
1. Overhaul of the market structure
Under the new rules, all organised trading is due to take place on regulated trading venues or Systematic Internalisers (SIs). To enable this, Organised Trading Facilities (OTFs) have been proposed to capture broker crossing networks and other multilateral trading in non-equity instruments which does not currently take place on regulated markets (RMs), MTFs or SIs. These new trading venues will be able to exercise discretion in order execution, trade on a proprietary basis on their own platform in illiquid sovereign bonds and trade on a matched principal basis in all bonds.
The idea behind this initiative is to induce competition by creating a ‘menu’ of structures for multiple kinds of financial products to be traded, from which investors can choose. At the same time, the obligations surrounding each structure ensure that they adhere to the same broad transparency requirements. Therefore, regulators and investors are able to monitor markets and track prices more easily.
It remains to be seen whether reclassification of single dealer platforms, broker crossing networks, MTFs and third country platforms, such as SEFs, will represent greater opportunity for flow, or impact the executable liquidity in non-equity markets. We could well see new platforms, utilities and markets forming to help cope with this massive transformation.
2. End of OTC?
Over the counter (OTC) derivatives trading and its opaqueness was viewed as one of the primary drivers of the 2008 crisis. In view of this, the biggest changes are thought to be felt in derivative markets, where reforms seek to implement the commitments made by the G20 in 2009 to move OTC derivative trading on to trading venues.
Michel Barnier, EU internal markets Commissioner, stated that MiFID II seeks to put “an end to the rule of opaqueness, and an end to the reign of over the counter transactions”. Under the new regulations, OTC trading will be moved to trading venues through a trading obligation for certain equities and derivatives.
With MiFID II forcing a reduction in OTC trading, where it does persist it will be generally be characterised by less liquid and more tailored products. As a result, many market participants are beginning to question whether or not it would be possible for OTC to exist in another form.
3. Increased transparency
The new regulation extends the scope of transparency requirements from just shares to other ‘equity-like’ instruments, such as depositary receipts, exchange-traded funds and certificates that are traded on regulated markets, MTFs and OTFs.
Increased transparency can be positive for investors, but one potential downside is that, in less liquid markets, it may have a negative effect on liquidity as the publication of trade data may undesirably impact the execution of trades entered into after execution. This could hurt the very price formation and best execution objectives pursued by the transparency requirements. However, one certainty is that MiFID II’s pre and post-trade transparency rules will cause a massive amount of new data to be published to the market.
The bottom line is that trading venues will need to implement invasive new systems and controls to comply with the transparency requirements, and members of these trading venues will have to consider what impact the revised regime will have on their trading activities.
4. Data overload
One area in which MiFID II will undoubtedly have an enormous impact is data publication. Collectively, the public presence of all of this new data will provide a banquet for firms and vendors alike to feast upon on post 3 January 2017, and the impact on the market is likely to be substantial.
With the quantity of data soaring and the complexity of computing systems to deal with it intensifying, the picture of how it works becomes more opaque and it becomes increasingly difficult for anyone to have an end-to-end view. This creates knowledge gaps between those who create the data infrastructure, those who build the computing systems, those who use those systems and those who make decisions based on the above.
As the industry has grown in size and complexity, the volume and risk within it have also multiplied. The more information that becomes available, the greater the ‘processing’ challenge to understand it. Analysing all of the data, all of the time, is impracticable. To extract meaning, the right questions have to be asked in the right way. This creates an ‘illusion of control’ where, because numbers are backed by complex models, people believe them.
5. Less global markets?
European financial services legislation has demonstrated a desire to impose extra-territorial requirements on non-EU financial services businesses that access the EU markets. In particular, this has been seen in the Alternative Investment Fund Managers Directive (AIFMD) and, more recently, in MiFID II.
As many third countries with developed regulatory systems may not satisfy the requirements, firms currently operating within the EU need to seek full authorisation. However, MiFID II provides Member States with discretion to require third country firms to establish a branch in their jurisdiction in order to do business with them. It is worth noting that the conditions required to be met for establishing a branch are challenging.
Although the UK is planning to exercise this discretion, it is not yet clear which other Member States will join it. Nevertheless, it is likely that countries which have conventionally been more protective of their markets will choose to require third country firms to establish a branch if they wish to access the retail markets in that jurisdiction.
Stay tuned for part 2, where we explore how MiFID II will impact the financial trading environment in terms of competition, investor protection, transaction reporting and the impact of unbundling, and whether the new rules will mark the end of dark pools.
As ever, you can learn more about MiFID II and how we can help by joining our LinkedIn Group.