MIFID II piece by piece: today impact on HFTs
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4 November 2011
It is worth noting that considering the current market turmoil, the timing and the scope of the review of MiFID, often called MiFID II, is clearly not ideal. Asking the European financial industry, which is still battling to overcome the impact of the financial crisis and now the sovereign debt crisis, to invest time and resources to adapt to a new regulatory environment may not be the wisest move. One has to remember that the first version of MiFID, that was less ambitious in its scope, was crafted during a period of bullish capital markets. The six main objectives of the MiFID review are to solve the issues around systematic risk in the derivatives markets, the implementation of position limit on commodities trading, the reinforcement of corporate governance, the strengthening of retail investor protection, the non-discriminatory access to trading venues, and finally the improvement of transparency in European capital markets and notably the fixed income one. I believe that the majority of market participants will all agree with these broad objectives, however, as usual the devil in the details. First of all, ensuring retail investor protection can drive very different agenda depending on the European country in which you operate. In certain country, the majority of retail investors will park their savings in mutual funds and insurance products, hence, to protect the retail investors, the regulators should actually, focus the traditional buy-side. In other markets, retail investors are active traders and conduct transactions directly through their retail brokers, therefore, the type of protections that they would require should be different from the first case. While it is easy to agree on high level concept, the difficulties in Europe is to find a consensus among so many different market practices and maturities. When it comes to HFT specifically, according to the commission, MiFID II goals are set to ensure market stability and avoid in the future the issue of trading venues outage and flash crash that we have recently experienced. I have been recently explained by a European MP that the reality of what I had interpreted in MiFID as a command for HFT operators to disclose their algos to the regulators was actually a requirement for HFTs to explain their high level strategies to the regulators to ensure sound market practice. One can be skeptical about the level of insights the regulators will get without analyzing in details the actual algorithms that are being implemented. Of course, this approach is unrealistic, regulators do not have the resources and capabilities to conduct an in depth analysis of the model that are being implemented by HFTs. Therefore, we may end up with a “cosmetic” amendment that will raise HFT operating cost without achieving the objective of the commission to increase the regulatory surveillance of HFT activities. But actually, the main elements of concerns for HFTs are two fold: - The potential implementation of a market maker obligation to provide liquidity on small caps. While one can understand the current concern of the commission that small caps are very illiquid and therefore limit the opportunity for corporate to rely on capital markets to raise funding rather than through banks’ loans. We nevertheless, need to take into account the impact of such requirements to the HFT risk exposure. With small caps, considering the limited volume that is being traded, the HFT market maker is very likely to hold an end-of-day exposure to certain stocks which would be for many of them, a clear evolution of their business model. In addition, without addressing the issue of trading venue pricing structure on small caps, this amendment is unlikely to achieve its end goal. - The launch of a Financial Transaction Tax (FTT) is a real threat to the HFT activity as it would jeopardize the economics of this industry. These concerns should be shared by players outside of Europe as well, since it will be included in the G20 discussions that are currently taking place in Cannes. Fortunately, MiFID II is not set in stone yet, and the industry have still time to come forward with data and rational to convince the European Parliament that some amendments and proposed regulations would be detrimental to the market, and therefore should be changed. It is already expected that over 2,000 new amendments and new propositions to MiFID will be discussed in the Parliament before the vote.