By Matthew Johnston What is MiFID II?
The original MiFID was the 2007 Markets in Financial Instruments Directive of the European Union, which was concerned with the trading of equities and its purpose was to minimise risk and increase investor confidence. This particularly focused on freeing the consumer from the monopoly of the stock exchange system. The subsequent 2008 financial crisis and recession showed MiFID to be a failure. Firstly, its content was unambitious and narrow, focusing only on stocks and ignoring other financial products such as fixed-income vehicles, derivatives, currencies and other assets. There were also issues of reach. The European Commission sought to protect European investors from fraudulent behaviour but failed to deal with financial products and firms based outside of the EU and decentralised those decisions to individual member states.
Subsequently, MiFID II was created to standardise practices across the Union and protect investors in a much more thorough manner. Of particular importance to the Commission, in its formulation of this new policy, were the dark pools and over the counter trading systems, because these reduced transparency and created a risk of fraudulent behaviour. Dark pools are hidden exchanges, inaccessible for the public, where institutional buyers and sellers can trade their securities privately without impacting the market price (this leads to price stability when carrying out high volume trades). The issue with these dark pools is that they lack transparency, hiding conflicts of interest (encouraging insider trading) and giving an advantage to those large institutional investors able to gain access. Over the counter (OTC) stocks are not listed on stock exchanges and tend to be much smaller companies. The issue here is that an absence of information on these companies can allow brokers to mislead investors or to carry out another type of fraud.
How did MiFID II deal with this legacy?
Coming into force in 2018, MiFID II improved upon its precursor by increased regulation and protection for investors. The first way it did this was much stricter regulation of the dark pools and OTC trading. Dark pools were limited to trading only 8% of a certain stock over 12 months. This regulation reasonably limited dark pools to their stated intention of preventing price fluctuations within the course of a trade and prevented (within a reasonable margin) individuals from profiting excessively from insider trading.
Another major issue that MiFID sought to aid is high frequency trading (HFT). Using algorithms and powerful computers to predict small deviations in future market price, they are very profitable, as they are able to act on market developments within milliseconds. HFT was already quite controversial in two main areas. Firstly, the mechanics of HFT mean that any market instability is exacerbated by HFT algorithms seeking to get in ahead of the curve. In this instance the EU didn’t seek to solve this problem in particular; instead it focused on transparency over separate HFT controversies. HFT has allowed firms to avoid capital rules. In 2014, Latour Trading LLC paid a fine for breaching net-capital rules (a requirement to have a certain amount of capital before trading) due to faulty calculations with their algorithm. In an effort to correct for this lack of transparency, MiFID II required HFT firms to register their algorithms and install circuit breakers to prevent rogue algorithms from performing unauthorised trades.
This push for transparency is echoed under another aspect of MiFID II. The European Commission saw a problem in the absence of a paper trail and oversight over trades. Just in the same way that HFT firms had to register their algorithms, every other trading firm now had to register their trades. This in particular concerns OTC trading where business is conducted over the phone. The main change was that institutions now had to report a high quantity of information about their trade immediately after the trade was concluded. This information included the price and volume and is timestamped to within 100 microseconds. At the peak of what is required to disclose, some trades must reveal 65 fields worth of information. This information is stored for 5 years. The commission sought by doing this both to increase regulatory oversight of malfeasance while also holding brokers accountable to clients, who are now able to hold their broker accountable to make sure they get the best price. Interestingly, this policy attempts to push brokers towards electronic trading, through which trade registration can be automated. This provides a passive benefit to the EU by normalising the easily traceable electronic method over the phone sale method which has major disadvantages for buyers.
Another major area where the EU thought investors were under protected was in the practice of market research. Similarly, to the problem with OTC trading, the Commission was under the impression that investors were being levied with hidden charges for very little gain in order to extract more fees. This problem had resulted from brokers bundling their transaction fees and their fees for research within the same package. This meant that investors often did not know what their money was being used for and could not compare different brokers. The idea was that if research could be directly linked to fees charged, quality would improve and fees could reduce.
There are also the ways in which MiFID was expanded both conceptually and geographically. The conceptual expansion was more simple and extended the requirements under the original MiFID as it applied to stocks to other financial instruments such as commodities, debt instruments, futures and options. Geographically it is more complex. The EU wanted to prevent MiFID avoidance via trading using markets outside the EU. So now, in order to trade anything with an underlying product located in the EU, that broker/investor must become MiFID II compliant.
The exceptions and discretion available to regulators in other countries is also worthy of note. Perhaps in an effort to prevent tension in international trade, the SEC in particular has been allowed to opt out American brokers from the MiFID regulations. In 2020 the SEC continued their policy of not enforcing the MiFID bundling regulations until 2023. However, the importance of this is arguable. On the one hand this characterises EU international financial regulation as flexible and conducive to cooperation, whilst leading to concrete effects. The TABB group of US equities asset managers found that of the 92 heads of desk polled, only 33% of them continued to bundle execution and research payments. This suggests despite MiFID’s international flexibility, it has been a success.
In terms of consequences, it is possible that in future, brokers could seek alternative ways of trading to avoid the MiFID II requirements, in the same way as dark pools buoyed in popularity due to the original MiFID.