A bigger bang

THE name may be unfamiliar—and comical—to most, but the first Markets in Financial Instruments Directive (MiFID) revolutionised share-trading in the European Union, by allowing new competitors to take on dear and dozy national stock exchanges. Earlier this month the European Parliament approved MiFID 2, an even more ambitious law, which aims to change how trillions of euros-worth of stocks and bonds, derivatives and commodities are traded, cleared and reported. The consequences are likely to be as sweeping and unpredictable as those of its predecessor.

MiFID 1, approved in 2004 and implemented in 2007, spawned a host of “multilateral trading facilities” (MTFs), electronic platforms for buying and selling shares. These, in turn, attracted outfits such as hedge funds hoping to profit from short-term market movements, which helped to moderate falling turnover and hone prices. Between a third and half of trading in the shares of Europe’s biggest companies now takes place off the old exchanges. Spreads have narrowed and fees have fallen.

But there were unintended consequences as well. With trading more divided among venues (see chart), it became harder to dispose of big blocks of shares without moving prices. So institutional investors, particularly, migrated to various forms of “dark” trading, which help to conceal the volumes they are buying and selling and the prices at which they are willing to deal. The impact of technology—the growth of algorithmic and high-frequency trading, for example—was not foreseen. Derivatives, contracts that take their value from an underlying asset, were overlooked. The financial crisis and the accompanying collapse in trading volumes from 2008 until the middle of last year highlighted these problems and sent regulators racing off in search of greater safety and more transparency.

The first target was largely unregulated derivatives. The Dodd-Frank act in America and, more slowly, the European Market Infrastructure Regulation (EMIR) began pushing them towards authorised venues. MiFID 2’s emergence has also been slow. The European Commission first proposed a new version in 2011, which financial-sector lobbyists, politicians and Eurocrats fought over to the bitter end. Diverging national interests played a role. So did a more fundamental tension between the needs of ever-bigger asset managers looking for liquidity and anonymity and retail investors with more to gain from transparency. Now that the parliament has approved a final text, the Council of Ministers will follow suit, leaving the European Securities and Markets Authority (ESMA) to suggest detailed rules to the commission. The new regime should be in place by 2017.

Its main thrust will be to force trading across all asset classes into open and transparent markets—not just equities, the focus of MiFID 1, or derivatives, the focus of EMIR’s clearing rules. Steps to make equity trading less opaque are especially controversial.

TABB Group, a consultancy, reckons dark trading constitutes 10-11% of the total, with almost 5% in MTF dark pools, where pre-trade prices need not be displayed, and almost 6% in brokers’ crossing networks, in which investment banks match orders in-house. Under MiFID 2, if trading in a particular share in dark pools exceeds certain caps, the pools will be barred from handling it for six months (although the darkness makes it hard to know when caps are hit). More confusingly still, the biggest dark trades need not be counted. ESMA is supposed to make all this workable. A ban on brokers’ crossing networks—which Judith Hardt, director-general of the Federation of European Securities Exchanges, says was her group’s biggest victory—is designed to push trades onto “lit” exchanges. But banks are beavering away on alternatives.

Automated trading, too, has provoked heated debate, especially the high-frequency sort which ESMA thinks accounts for over a fifth of European share-trading by value. A proposal for a mandatory half-second freeze on orders was dropped. Instead, algorithmic traders must register their formulae with regulators and introduce circuit-breakers. The members of the European Principal Traders Association, the main exponents of high-frequency trading, do not mind this so much, says Johannah Ladd, its secretary-general. But they are worried about plans to force certain traders to offer continuous quotes to buy and sell shares—a step that may simply drive them out of the market.

That is only one of many rows ESMA must resolve. It is also supposed to harmonise trading venues’ position limits for commodity derivatives and to ensure that exchanges provide pre- and post-trade information at a reasonable price, eventually consolidating data in a single source. Another pending rule will one day prevent exchanges from keeping their clearing and settlement facilities for their own users, consigning exclusive “silo” models such as Deutsche Börse’s to history.

Market operators are not waiting to see the fine print. Three new exchanges have set up shop in the past year. Last May NASDAQ OMX started a derivatives exchange, NLX. It reckons it has 10% of the market in certain interest-rate contracts. Aquis Exchange, an equity-trading platform which launched in November, charges customers an “all-you-can-eat” subscription fee based on their expected traffic rather than a percentage of value traded. Chicago-based CME Group, operator of the world’s biggest futures market, plans to open a European outpost on April 27th.

Existing outfits are making changes too. BATS Chi-X, an MTF which became the biggest trading venue in Europe before being recognised as an exchange in 2013, has begun listing exchange-traded funds and is cornering the market in the mandatory reporting of over-the-counter trades. Turquoise, an MTF part-owned by London Stock Exchange Group, has raised its share of European equity-trading by coming up with an auction system to protect institutions from predatory traders. Liquidnet, an institutional equity-trading network, is branching out: in March it said it was buying Vega-Chi, a corporate-bond platform.

Taken with other new regulations, the impact of MiFID 2 will be profound, thinks Rebecca Healey of TABB Group: “When you attempt this level of change, it is akin to using a sledgehammer; the risk is the chips will fly off in all directions, and not always the one you intended.”

Britain opposed MiFID 1 for fear that it would undermine the City, according to Tim Rowe of the Financial Conduct Authority. When the first draft of MiFID 2 was unveiled Britain opposed curbs on dark pools and brokers’ crossing networks for much the same reason. In fact, he argues, London proved the great winner from MiFID 1, for it was able to adapt to change. The only certainty this time is that there will be even more of that.