I believe that uncertainty is really my spirit’s way of whispering, “I’m in flux, I can’t decide for you. Something is off-balance here”

I will reveal the source of this quote later, but one can imagine the policy makers at the EU Commission sitting around a table in the late 90’s and thinking, “you know this ISD, it ain’t quite working is it?” 

MiFID – a potted history
The ISD is the Investment Services Directive – introduced in 1993, it set the legislative framework for investment firms and securities markets in the EU, providing for a single passport for investment services.   It was seen as the trigger for a more dynamic EU securities market to rival the US, and one which would foster innovation and efficiency while maintaining an adequate level of protection for end-investors.

By the end of the millennium it was becoming obvious the ISD was not achieving its aims.  The main reason was that Members States’ protectionist tendencies had prevailed over the spirit of openness anticipated in the Directive.  It was also the case that the ISD could not keep pace with market developments of the late 90’s when securities’ managers and markets were going through a period of evolution – offering more complex products not foreseen in the Directive.  One of the major consequences of this was that regulators then tried to correct failures in their own local markets, which aggravated an already complex regulatory landscape for firms that operated in different EU jurisdictions.  After much deliberation, the EU Commission came up with a solution to the problem, the evolution of  ISD2, and the updating of the ISD into MiFID – the Markets in Financial Instruments Directive. 

MiFID – a brief reminder 
MiFID seeks to address the deficiencies of the ISD by harmonising compliance standards, conduct of business rules and market practices (trading and dealing) that would enable firms to operate freely and consistently across the Continent.  The Directive’s planned implementation date is 1 November 2007.

Key impact for market participants
Investors: for investors MiFID should be positive.  Firstly, the Directive will introduce an EU wide client classification regime, which is broadly similar to the existing FSA approach in that it is based on providing the greatest level of regulatory protection to “less sophisticated investors”. 

MiFID anticipates much more interaction between firms and their clients: firms will have to consider new Know Your Customer requirements (suitability and appropriateness); firms will have to agree a broader approach to best execution based on clients’ needs, which will have to be documented, and the firm will also have to actively manage all conflicts of interest both within the group and between the firms and its clients. 

Combine all of the above with the new client reporting provisions and MiFID not only provides investors new regulatory protections, it also equips clients with the tools necessary to compare, contrast and question the quality of services received from different providers.

Firms: well, where does one start?  Once school of thought says that MiFID is “FSA-type” regulation for the rest of Europe; another school of thought holds the opposite view.  There is no doubt that MiFID is prescriptive in that it introduces rules at almost every level of the firm with an over-riding responsibility on senior management to make sure their firms are compliant.  And where have you heard that before – yes the FSA of course.

For most UK firms save for Broker/dealers, MiFID will probably be a reincarnation of N2; indeed some are calling it N2+6!  The route to compliance will involve quite a lot of reviewing and mapping and will result in some changes to existing processes – the sort of thing most firms can manage with careful planning.  That’s how Threadneedle has approached its planning to date, and which is now at advanced stage where systems and non-systems solutions are being identified and costed.  

Dealing practices however will change radically: fewer clients will be able to opt out of best execution and the way firms seek best execution will vary between clients; in addition all clients will be owed a duty of conflicts management.  The number of execution venues should increase: MiFID formalises current practices of ‘alternative trading’ and ‘banks’ principal trading’ in certain stocks into Multilateral Trading Facilities and Systematic Internalisers respectively.  This has the potential to increase competition but it could also lead to a fracture in liquidity and market data.  The cost of MiFID implementation for investment banks has been estimated at billions, but it is difficult to know how of much of this cost relates to UK based operations.

Regulators: whisper this but the FSA is by far the most evolved regulator in the EU – so much so that it is seeking to move towards principles rather than prescription as its regulatory platform of choice.  Despite what they say, MiFID will put a brake (albeit a temporary one) on the FSA’s move towards principles.  Article 4 of the Level 2 MiFID Implementing Directive could also mean that FSA has to review existing rules that go beyond MiFID and more significantly it should check any plans FSA has for super-equivalence.  For EU regulators, MiFID will create bigger challenges: for most, detailed conduct of business rules will be a new concept and will require careful implementation – often into national law.  The end of the so-called concentration rule may create tensions between local regulators and local exchange monopolies that may not welcome the increased competition – especially from Passporting Multi lateral Trading Facilities (MTFs).

Winners and losers
It is probably too early to be predicting winners and losers in a post MiFID landscape, but developments so far suggest that compliance departments should be smiling (ok, be a bit less miserable) – the Directive affords them more responsibility, which should mean more influence within their firms.  As mentioned earlier if national regulators embrace the spirit of MiFID then firms operating cross-border should find it is easier to do business.  MiFID will also make it possible for individual firms to become MTFs, but MTFs are more likely to develop with collaboration amongst a number of firms.  MiFID will invariably require systems’ change so vendors are rubbing their hands with glee (Y2k again?); likewise for the vendors’ ugly sister – the consultants, MiFID fills the financial void left by Basel 2.

Losers (and I use the term loosely): probably local exchanges whose power base should be threatened – both in terms of business volume and other revenue streams such as market data.  For example, in the UK, a consortium of 10 banks have organised under ‘Project Boat’, which will present a direct challenge the LSE’s provision of market data.  It has been suggested this could reduce the LSE’s revenue by 43%.  Finally, if MiFID is successful in its objectives then those firms who currently have their head in the sand vis-à-vis implementation could find the longer they leave it the more expensive it becomes to achieve compliance – they may also miss out on new commercial opportunities, which MiFID presents. 

Final thoughts
Most Directives including biggies such as Basel 2 are – to a more or lesser extent discrete pieces of a regulatory jigsaw.  MiFID is a whole jigsaw in itself!  It impacts all the major players in the market: Broker/dealers; Investment Managers; Exchanges; Distributors and Regulators.  Yet while participants expect a certain amount of transitional turbulence post implementation, the prevailing pre-implementation sentiment   running through the industry is uncertainty: uncertainty with respect to how regulators across the EU will implement different parts of the Directive, uncertainty as to how the market will look post-MiFID.  And while both issues are causing a great deal of concern at Threadneedle, ‘predicting’ the latter (i.e. the shape of the market post-MiFID) is probably the most trying: will liquidity in certain stocks disappear and will it reappear at a Systematic Internaliser – indeed which firms are going to be SIs, and is Project Boat the forerunner to a powerful pan-European MTF? 

If the EU wants to compete longer term with the U.S., counter the threats from emerging markets, and take advantage of increased globalisation then it needs to wake up from its current stupor.  MiFID is the Commission’s response at harmonisation, and probably a step in the right direction.  Time will tell if MiFID was the shot in the arm the industry needed or whether it was a misguided (and expensive) attempt to correct market failings.  It is therefore suggested that MiFID’s ultimate success will be determined not by firms but by local regulators accepting that firms authorised in one EU jurisdiction should be entitled to a level-playing field in another jurisdiction, and that they must be prepared to put single market interests ahead of national interests.

By the way the not so prophetic quote was from Oprah Winfrey!

Notes to Editors
Please note that this article reflects the author’s personal comments and not those of Threadneedle Investments.