By Mahima Gupta and Shashin Mishra, Sapient Global Markets
Originally published on Tabb Forum
While the key objectives of the Markets in Financial Instruments Directive I were to bring greater standardization and improvements in collateralization and risk management, MiFID II seeks to enhance transparency and supervision to ensure methodical markets and harmonize reporting requirements across member states. What obligations does MiFID II impose on investment firms, and what will be the associated impact and operational challenges?
MiFID I came into effect in 2007 to facilitate cross-border financial services within Europe, ensuring a competitive landscape between trading venues while safeguarding the interests of consumers and investors. This was followed by the global financial crisis of 2008 that necessitated subsequent regulations to ensure tighter control and supervision of over-the-counter (OTC) derivatives market activity. Until that point, MiFID I was only a directive. However, these developments, along with the technological and financial innovations across the industry, mandated an update in the legislation. Member states must now enforce both the directive and the regulation by January 2018.
Though the regulators released the final proposal for MiFID II in October 2011, it is garnering the requisite attention only as the deadline approaches. The industry has been busy meeting compliance obligations for European Market Infrastructure Regulation (EMIR), which had an earlier deadline of 2013 and a lesser scope forming a stairway to prepare for the larger directive—MiFID II. The European Securities and Markets Authority (ESMA) was also delayed in drafting its requirements and technical standards for the industry to follow.
When it became evident that the industry was struggling to make the necessary preparations to be compliant with MiFID II, the European Commission delayed the compliance timeline to January 2018. However, even with an extra year, reporting participants cannot delay preparations to meet the obligations due to the numerous challenges they must address, requiring focused attention and substantial effort.
MiFID II reporting requirements are generally divided into two categories: transparency reporting and transaction reporting.
Transparency reporting consists of obligations to report both pre-trade and post-trade information on potential and final transactions, respectively. MiFID II extends the reporting requirements to a wider universe of instruments that includes:
- “Non-equity” instruments, such as structured finance products, bonds, emission allowances and securitized derivatives. These are to be traded on newly introduced organized trading facilities (OTFs), which are multilateral trading systems that are not regulated markets (RMs) or multi-lateral trading facilities (MTFs). They can execute orders on a discretionary basis, but not against their proprietary capital.
- “Equity-like” instruments, in which the underlying is an instrument traded on a trading venue or submitted for trading on a trading venue, or an index or basket composed of instruments traded on a trading venue.
Pre-Trade Transparency Reporting
Reporting MiFID I had pre-trade transparency reporting applicable for equities traded on platforms such as MTFs. MiFID II extends these requirements to non-equity instruments and applies to OTFs as well.
This entails the reporting of a range of bid and offer prices or quotes as well as the depth of trading interests at those prices, or indicative pre-trade bid and offer prices that are close to the price of the trading interest. These have to be reported to consolidated tape providers (CTPs), which combine and publish trading prices and volumes from exchanges. By virtue of this reporting requirement, CTPs will have access to a continuous electronic data stream of pre-trade market quotes which, when available to market participants, will enhance transparency and aid market stability and trustworthiness. The only exemptions include large-scale orders and illiquid financial instruments.
Post-Trade Transparency Reporting
For all equity-like instruments, RMs, MTFs and OTFs must publish the price, volume and time of transactions executed in their platforms as close to real-time as technologically possible, preferably within seconds. This information must be published via Approved Publication Arrangements (APAs). Deferred publication is available for certain conditions, such as large-scale orders and illiquid financial instruments, as with pre-trade transparency reporting.
Firms will need to report more data fields under MiFID II than they did under MiFID I. Some of the new information includes the traders’ and decision makers’ details, such as personally identifiable information and more granular time stamps. The objectives of these changes are to enable regulators to trace back the transaction footsteps when investigating potential market manipulation and to track down accountable personnel. This detailed post-trade information must be reported by Approved Reporting Mechanisms (ARMs).
While market participants, such as central counterparties (CCPs), are not liable to report pre-trade and post-trade transparency information, they would be required to report transaction details for the trades that are cleared through their platforms. However, investment firms have an obligation to adhere to all three reporting requirements. This is especially true if the firm functions as a systematic internalizer (an investment firm which, on an organized, frequent and systematic basis, deals on its own account by executing client orders outside a regulated market or an MTF).
Operational Challenges with Reporting
Although the industry has addressed multiple issues when dealing with Dodd-Frank, EMIR and other regulatory reporting across jurisdictions, MiFID II presents new challenges. Some of these are data management-related and some require infrastructure upgrades. Reporting participants will be faced with the following operational challenges:
Periodic Changing of Liquidity Categories
Instruments under the “non-equity” category will be periodically assessed for their liquidity. If deemed sufficiently liquid, the instruments will receive a waiver from reporting pre-trade transparency information and granted permission to defer publication of post-trade transparency reporting.
As a result, reporting firms will have to keep tabs on the liquidity status of their traded non-equity instruments and switch between reporting pre-trade transparency and real-time post-trade transparency. While many non-equity instruments will fall under the illiquid criteria for some time to come, a few may cause operational nightmares with their frequently changing status.
Similarly, even when sufficiently liquid, these instruments can get above waiver and time allowance based on other trade-specific parameters, such as an order exceeding a size specific to an instrument. These thresholds will also be defined by ESMA and will be revisited regularly. This will incentivize firms to trade above a certain size and may result in an increase in block trades for these instruments.
Multiple Channels of Connectivity
A new regime of data consolidation and reporting to entities, including consolidated tape, APAs and ARMs, pose operational complexity and put pressure on resources. While the purpose of each of these entities is different, as is their directive to receive and collate respective data (as noted in Figure 1, below), the industry would benefit if a single entity could provide all three services.
However, that doesn’t seem to be the case at present. More than one existing ARM under MiFID I plans to register as both an APA and an ARM, but have different specifications to follow and possibly will need to create separate systems as well as legal entities to do the job. This will lead to less harmonization across the board and will add to the reporting complexity for market participants, unless they decide to register as direct submitters.
Time Sequencing and Clock Synchronization
Regulators are asking for the ability to rebuild trades by accurately time sequencing both preceding and subsequent events. Accuracy is expected in microseconds for algorithmic and high-frequency trading, and one second for manual trades.
To avoid scenarios in which data can appear to travel backwards in time because it was sent from one location to another that had stamping clocks slightly behind the first one, firms need to revisit how they implement time and stamp data packets. They will have to synchronize their clocks to an authorized location of Coordinated Universal Time (UTC) as clock drifts would no longer be acceptable. Releasing data for public dissemination on a consolidated tape—even a few microseconds earlier—may result in market impact, placing other firms at a disadvantage and risk of regulatory breach.
Managing Personally Identifiable Information (PII)
PII, as used in US privacy law and information security, is information that can be used on its own or with other information to identify, contact or locate a single person, or to identify an individual in context.
MiFID II reporting includes information on the buying trader, selling trader and even the advisor on behalf of any party. This information is not limited to name, country of residence or even date of birth. It is personal information such as “national identifier” and passport numbers. Figure 2, below, summarizes PII options as outlined by MiFID II. Each piece of information, if it reaches the wrong hands, can jeopardize a person’s identity. This information can also be misused to execute wrongful trades on the person’s behalf, thus compromising his or her integrity and career.
Every entity in the MiFID II reporting chain—including banks, venues, third-party reporting service providers, APAs, ARMs and regulators—must have the requisite security measures in place to protect the identities of the industry personnel involved.
Non-Reporting Operational Challenges
Apart from the operational challenges, firms must also consider a variety of business impacts that will require changes in either process or infrastructure, or both.
Pre-Trade Transparency Reporting
As firms make their quotes on OTC and non-equity orders public in real-time, competitors will have a chance to fill those orders. Thus, firms will need to adjust their sales, pricing and risk management systems to account for such lost opportunities, as well as to quickly react to competitive opportunities.
New Category of Trading Venues
Under MiFID II, OTFs are being established to bring OTC derivatives onto exchange-like venues. While the creation of OTFs is expected to increase market transparency and competition, it will also reduce bilateral risk in the system. Plus, it will change the market dynamics where existing platforms may choose to become OTFs or MTFs. The presence of so many platforms in the market will result in fragmentation that may in turn make price discovery more difficult, although pre-trade and post-trade transparency reporting will try to address that issue.
Commodity Trading Operations
Under MiFID I, non-financial market participants trading on their own account in commodities and derivatives to hedge their core business risk are exempt from reporting obligations. With MiFID II, non-financial market participants must not only prove that their trading activity demonstrably reduces the risks attached to their core commercial activity, but they must also prove that the capital employed for carrying out this activity is their own.
MiFID II is one in a long line of regulations that are forcing market participants to fundamentally change operational systems and processes—and consider broader business impacts. At the same time, these organizations are also facing the ongoing pressure to reduce operational costs.
Continuing to add functionality to internal systems and tack on new modules to address requirements from multiple regimes is an approach that is simply no longer sustainable from a cost perspective. What’s more, in-house systems take away critical and costly resources from projects designed to support revenue growth or business expansion.
Leveraging a system designed from the ground up to manage reporting requirements can help firms address compliance needs in a cost-effective and scalable manner. It can be modified to comply with existing regulations, giving firms a strategic structure for similar needs while achieving further economies of scale. Finally, it can help firms collaborate if they are using the same systems as their peers, driving a common view of reporting best practices. With the extended deadline for MiFID II, market participants have the time to change course and capitalize on an approach that can not only minimize the cost of reporting, but also help drive business value by establishing a long-term extendable platform.