MiFID: Spirit and Reality of a European Financial Markets Directive

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27 September 2010



The goal of this report is to describe the objectives and spirit of MiFID and compare it to the status quo and evolution of the European equity trading landscape, with a specific focus on the role of the different categories of trading venues. It serves to assist the current industry and regulatory discussion and provides proposals for possible future regulatory adaptations and enhancements.

The key idea of the Markets in Financial Instruments Directive MiFID was to establish a comprehensive regulatory regime governing trading in financial instruments irrespective of the trading methods used to conclude those transactions in order to promote market efficiency, market integrity, fairness, and competition among various forms of trading mechanisms and venues. Now three years after the implementation of MiFID, the reality of European markets reveals that the competition between Regulated Markets and the newly emerged MTFs works in favor of investors and has led to the desired effects in terms of technology and trading model innovations, service competition, significant fee reductions, and improved market quality in terms of reduced spreads and deeper order books.

Despite a rise of the number of trading venues available to investors, from regulated markets to MTFs and dark pools, transactions carried out on an OTC basis still represent a significant and stable part of the overall trading volume executed in the European cash equity market. However, MiFID characterizes OTC transactions in Recital 53 as transactions that cumulatively fulfill the requirements of being ad hoc and irregular, carried out with wholesale counterparties, above standard market size, and conducted outside systems used for systematic internalization. The analysis of individual OTC transactions in this study reveals that currently the majority of OTC transactions are not larger but smaller than standard market size. Peter Gomber, who holds the Chair of e-Finance at the Goethe University of Frankfurt and is coauthor of this report, says that: “If—as most market participants state—the minimization of market impact is the central motivation for OTC trading, one should expect that most OTC trades would face market impact if concluded on the reference market. However, our analysis reveals that most OTC trades are rather small and would not face market impact. The structural differences between OTC trading and primary market trades are overestimated in the public discussion.” In 2009, five out of ten OTC trades in high liquid shares and six out of 10 trades for a sample of less liquids ones were below the MiFID standard market size. The share of OTC trades that would face no market impact increased from 68% in 2008 to 80% in 2010 for high liquid shares and from 58% in 2008 to 66% in 2010 for a sample of less liquids ones.

The fragmentation of venues driven by the opening of venue competition due to MiFID has accelerated the adoption of trading technology from order management systems to algos and smart order routing systems. These technologies have changed the way trading is conducted in the European cash equity market. “Not only has it driven a decrease of transaction sizes but it has also made market data, both pre- and post trade, more crucial to market participants, because this information is necessary for this computer-based trading to operate”, says Axel Pierron, Celent Senior Vice President and coauthor of the research report.

The concern about information leakage is driving an increase of order execution in the dark side of the market, be it through dark pools, crossing networks, or OTC. Mr. Pierron adds: “Broker/dealers have developed matching engines to electronify their OTC activities that were mostly conducted over the phone in the past. This is a clear improvement for the industry as a whole since it will decrease the likelihood of mismanaged orders; improve the post-trade processing and reporting. However, Broker/Dealer crossing networks (BDCNs) do not provide a unique model of execution. In reality, BDCN operations could qualify for all three venue classifications created by MiFID.”

The report also analyzes the impact of the OTC trading volume to the structure of the European equity market and demonstrates that the current level of transactions that are conducted OTC could pose a real threat to the order-driven model of the European cash equity market. The situation is even more acute with the development of BDCNs that could capture more market share from the regulated trading venues (regulated markets, MTFs, SIs). “With negotiation happening in the OTC space, the price discovery mechanism happening on the ‘lit’ market could be severely impacted, eventually pushing the equity market to become a quote-driven market,” explains Mr. Gomber.