Richard Gissing assesses the implications of MiFID for Gissing Software clients now that the Level 2 documentation has been published
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This document presents the key issues from the MiFID Level 2 documents that are relevant to Gissing Software and its clients. Thus it relates mainly to the Transparency obligations of MiFID, with brief reference to the Best Execution obligations. All other aspects of MiFID are beyond the scope of this document, as they have no direct bearing on the application of Gissing Software technology or the business opportunities that MiFID may present for them.
Best Execution
The Best Execution obligations of MiFID have been issued as a Directive, which means that they will have to be translated into national law in each of the 30 affected countries with some scope for "tailoring" to meet national requirements. It is strongly stated, however, that the purpose of the directive is to create a harmonised regime across Europe, and consequently such "tailoring" must be justified and must pass certain criteria in order to be permitted by the EU. In other words, it is not an invitation to "gold plate" the directive to add further obligations that the EU deem unnecessary.
 The Level 2 guidance clarifies that Best Execution obligations apply to transactions in all financial instruments (therefore including FX). It acknowledges, however, that the lengths to which best execution can include comparisons (i.e. checking multiple venues for the best overall price) are limited for some instrument types (e.g. a custom OTC derivative) due to the unique nature of the instrument and the difficulty to obtain comparative quotes without providing access to the client specific information. Nevertheless, the lack of a wholly reliable benchmark comparison does not relieve an investment firm of its Best Execution obligations. This means that the pricing of the instrument should be sound to the extent it takes reasonably into account the market values of the variables that enter into the pricing process or, where possible, use available comparisons and a realistic assessment of risk. In other words, the firm is going to need access to a reasonable quantity of underlying market data from multiple sources (or a consolidated feed from multiple sources) whatever type of instruments it is trading in order to meet Best Execution obligations.
Outsourcing obligations with respect to Best Execution have also been clarified by the Level 2 documents. A firm that outsources execution to another firm can meet its Best Execution obligations to its clients by examining the market, choosing a firm that it believes will be able to deliver Best Execution on its transactions, monitoring the execution quality of that firm and correcting any deficiencies as they arise. Presumably they will need access to good quality post trade data in order to monitor the execution quality. This will be straightforward initially for equities under MiFID, but it's not clear how this obligation can be met for other instrument types until the MiFID transparency rules are extended to include them.
Transparency - General
The pre-trade and post-trade Transparency obligations of MiFID have been issued as a Regulation at Level 2. This means that they must be implemented exactly as written, with no scope at all for changes at the national level. This is extremely helpful to companies such as Gissing Software that are designing technology solutions since the rules will be identical across all participating countries and, once ratified by the European Parliament (which at the time of writing is scheduled for June/July 2006), can be acted upon with certainty.
The definition of liquid shares has been clarified. It is estimated that there will be approximately 500 liquid shares, which represents more than 90% of the EU market by turnover. Countries that do not have 5 or more shares falling into the MiFID definition of a liquid share may nominate certain 'local' shares to be deemed as liquid. In this situation the total number of liquid shares, both real and nominated, for this country may not exceed 5 (e.g. if they have 2 real liquid shares they may nominate up to a further 3 to be deemed liquid).
The criteria for the definition of a Systematic Internaliser have been provided by the Level 2 regulations, as follows:
Where an investment firm deals on own account by executing client orders outside a regulated market or an MTF, it shall be treated as a systematic internaliser if it meets the following criteria indicating that it carries on that activity on an organised, frequent and systematic basis:
- the activity has a material commercial role for the firm, and is carried on in accordance with non-discretionary rules and procedures;
- the activity is carried on by personnel, or by means of an automated technical system, assigned to that purpose, irrespective of whether those personnel or that system are used exclusively for that purpose;
- the activity is available to clients on a regular or continuous basis.
An investment firm will cease to be a Systematic Internaliser in one or more shares if it ceases to carry on the activity specified above in respect of those shares, provided that it has announced in advance that it intends to cease that activity using the same publication channels for that announcement as it uses to publish its quotes or, where that is not possible, using a channel which is equally accessible to its clients and other market participants.
The exemptions from the transparency obligations have also been defined.
Pre Trade Transparency
Pre Trade Transparency obligations have been clarified for Regulated Markets (RMs) and Multilateral Trading Facilities (MTFs) with different "market types", as follows:
- Continuous Auction Order Book - the aggregate number of orders and of the shares those orders represent at each price level, for the five best bid and offer price levels
- Quote Driven - the best bid and offer by price of each market maker in that share, together with the volumes attaching to those prices
- Periodic Auction - the price at which the auction trading system would best satisfy the system's trading algorithm and the volume that would potentially be executable at that price by participants in that system
- Hybrid - maintain a standard of pre-trade transparency that ensures that adequate information is made public as to the level of orders or quotes for that share, as well as the level of trading interest in that share. In particular, the five best bid and offer price levels and/or two-way quotes of each market maker in that share shall be made public, if the characteristics of the price discovery mechanism permit it
Pre Trade Transparency obligations for Systematic Internalisers appear to be mostly unchanged from Level 1, however the definition of Standard Market Size for each class of share has been provided (shares are split into several classes based on average transaction values for that share). The obligation for each liquid share for which they are a Systematic Internaliser is to maintain a firm quote (or quotes) which are close in price to comparable quotes for the same share in other trading venues. Each quote must contain bid and/or offer price(s) and associated size(s) and may be for any size up to Standard Market Size. Multiple quotes may be maintained for the same share at different sizes. Quotes may be withdrawn due to "exceptional market conditions" (for example, something major happening which causes a run on the market).
Systematic Internalisers must maintain a record of each quoted price for a minimum of 12 months.
Systematic Internalisers must trade with clients at the quoted price for orders up to Standard Market Size, however for "Professional" clients they may price improve if the order is larger than "retail size", which is defined as in excess of EUR 7,500. Note that Standard Market Size and Retail Size are not necessarily the same.
Post Trade Transparency
The requirements for Post Trade Transparency remain unchanged from the Level 1 Directive; all organisations covered by MiFID must publish trade reports for every trade they complete in a share admitted to trading on a regulated market as close to real-time as possible, and in any event within 3 minutes of the trade taking place.
The requirement for near real-time publishing has been underscored; real time should be the target, not 3 minutes.
The exception to the near real-time publishing obligation is for "large transactions", which may be published on a delayed basis so as not to expose a position to the market. The rules defining the length of delay against the size of transaction have been provided.
One piece of information that must be published in the trade report is the identity of the execution venue, which for a Systematic Internaliser would be itself. The rules allowing a Systematic Internaliser to use the acronym "SI" rather than identifying itself have been provided. Essentially, in order to do this a Systematic Internaliser must publish to the market (but the documents don't specify how often) aggregate trade information for the previous 3 months in relation to the share in question.
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