THE MIFID REVIEW: Tough But Necessary Change Or Death By A Thousand Rules?

The European Commission's much-heralded Review of MiFID (the Review) was published in December for public consultation. The consultation is open until 2 February 2011 and the Commission proposes to put forward a formal proposal for legislation in Spring 2011.

The Review solicits responses on proposals to change the scope and detail of the firms, clients, financial instruments and practices to which MiFID presently applies. The headline themes of the Review are, in the Commission's own words, to "bolster investor confidence" and "address the more complex market reality... which is characterised by increasing diversity in financial instruments and methods of trading".

Some of the measures proposed are self-evidently matters of regulatory policy playing catch-up with market developments, for example in relation to new trading methods. More worryingly, other measures demonstrate a prescriptive and rigid response to a perceived or suspected potential for investor detriment. In some cases, indeed, the Commission's suggested measures (or more accurately, options for measures) seem to cross the line between the regulation of firms' conduct and the imposition of specific conduct requirements, even to the extent of banning certain products or activities.

The underlying political themes are by now familiar:

There is the response to the financial crisis – at one extreme, the search for villains (real or imagined) to be held to regulatory account; but in any case the desire for more monitoring, greater transparency and greater powers of regulatory intervention. There is the assessment that the EU's single market is still fragmented, especially due to the different standards and priorities of national governments and regulators; and that the way forward is more centralisation and the imposition of uniform regulatory standards – in short, a further move towards a single European rulebook. There is a consumer protection agenda, driving more onerous conduct of business requirements, extending far beyond what would usually be recognised as the retail market and impinging on the ability of some market participants to agree their own bargains regarding liability for failed or inappropriate investments. This briefing paper comments on some of the more interesting and concerning of the proposals canvassed in the Review and in doing so questions whether the regulatory developments now proposed by the Commission are ultimately a necessary response to a changed market environment or a case of over-zealous prescription which risks smothering the market.

The main themes in a nutshell

Technical changes to adapt MiFID to developing market practices (e.g. to capture OTC trading which has features of exchange trading)... ...but a political agenda lurking behind many such changes (e.g. suspicion of OTC and automated forms of trading) A push to regulate a greater number of commodities markets participants An emphasis on greater transparency, particularly in non-equity markets The lighter-touch regimes for eligible counterparties and professional investors to be narrowed (principally by limiting their scope and ending certain presumptions as to knowledge and experience) Much greater protection for retail clients in respect of execution only and advisory services (but arguably over-protection) Worrying new powers for both EU and national regulators to intervene in markets to halt particular activities or to ban particular products 1. Organised trading systems – redrawing the boundary between regulated and OTC trading

Only certain categories of trading venue are currently regulated under MiFID:

regulated markets (which is an optional status); multi-lateral trading facilities (essentially rule-governed market places not having "regulated market" status) (MTFs); and systematic internalisers (investment firms dealing on their own account, with their own capital, to execute client orders on an "organised, frequent and systematic basis"). Very few investment firms identify themselves as systematic internalisers: the Commission states that as at the date of the Review only 10 firms had done so. Other organised trading systems have developed outside these MiFID categories, many of which are not currently subject to specific supervisory oversight as trading venues, including broker crossing systems and inter-dealer broker systems. These are typically automated systems developed by investment firms to match client orders. Trading through such systems at present constitutes OTC trading, albeit that it takes place in an organised and systematic environment.

The Commission is anxious to bring such systems, and the large volume of off-exchange trading which they facilitate, within the regulatory perimeter, so that their operation would become an investment service requiring specific authorisation and, consequently, supervisory oversight.

A broad definition is proposed, along the lines of "any facility or system operated by an investment firm or market operator that on an organised basis brings together buying and selling interests or orders relating to financial instruments". This broad definition would leave outside the trading venue perimeter what the Commission considers to be 'pure' OTC trading – bilateral trades carried out on an ad hoc basis between counterparties and not through any organised trading facility or system.

The main point of this revision would be to allow regulators to identify such systems and to apply certain basic requirements to them, chiefly of a prudential or monitoring nature (monitoring to include co-operation and information sharing to better facilitate monitoring for market abuse). Pre-trade transparency (i.e. obligations to publish, in real time, current orders and quotes relating to the relevant securities) would not be a requirement, but post-trade transaction reports would identify any system through which a transaction had been executed.

In addition to proposing the application of basic prudential and monitoring requirements for non-exchange organised trading systems, the Commission goes on to suggest that the reform of MiFID allows for the creation of additional targeted 'sub-regimes' for various categories of organised trading system:

The example discussed in the Review is that of broker crossing systems, although little detail is provided about such a sub-regime. The Commission clarifies, however, that "operating a crossing system" would not be regarded as additional to, rather than an alternative to, seeking MTF or systematic internaliser status: if third parties are able to enter orders into a crossing system this would transform the system into an MTF, where different standards would apply, including the possibility of mandatory pre-trade transparency; similarly, if a firm executes orders within its crossing system against its own capital the rules applicable to systematic internalisers would apply. When viewed alongside proposals now being made in parallel initiatives, such as the Commission's proposal to extend the market abuse regime to securities admitted to trading on MTFs as well as regulated exchanges, it is possible to identify a trend in the Commission's policy thinking. The ultimate objective might be, one way or another, to bring the substantial portion of trading which currently takes place off-exchange, and in many cases in so-called 'dark' venues1, out of the darkness and into the spotlight of mainstream supervision, transparency and market monitoring. At this extreme, regulators would be required to perform a supervisory role for, and have access to monitor, virtually all organised trading venues within Europe.

An MTF or regulated market would be permitted to operate a dark pool only by applying for a waiver. One consequence of the organised trading facility proposal described above (together with proposals elsewhere in the Review to tighten the pre-trade transparency waiver regime for regulated markets and MTFs; see section 5 below) would be an ability for regulators to intervene by switching the lights on in all dark pools, should politics or other circumstances require.

A key policy theme that has pervaded G20 and EU debates on regulatory reform is that transparency and greater regulatory intervention will promote greater stability in the financial markets. In light of this, there appears to be a concern at the Commission (perhaps with encouragement from some of the more exposed Eurozone Member States) that dark venues – whose proliferation has of course been a direct result of the market liberalisation project enshrined in MiFID – may have enabled dubious or malevolent trading strategies. The Commission appears...