Experts see trouble ahead from MiFID II

European market regulators' efforts to apply equity templates to trading in other asset classes will be felt by U.S. money managers and asset owners through higher trading costs, reduced investment performance and a potential move to more in-house management by asset owners, industry analysts said.

The European Securities and Markets Authority, which is creating European market rules for non-equity trading, “has gone a bit too far this time,” said Tom Conigliaro, managing director and head of investor trading services at financial services data provider Markit Group Ltd., New York. “The impacts probably will be more draconian and troublesome than regulators realize.”

The concern centers on Markets in Financial Instruments Directive II, an update and expansion on securities trading rules imposed through MiFID I in 2007 that focused on equity markets. MiFID II, to take effect in January 2017, “introduces a market structure which closes loopholes and ensures that trading, wherever appropriate, takes place on regulated platforms,” according to a statement on the ESMA's website. “It improves the transparency and oversight of financial markets — including derivatives markets — and addresses the issue of excessive price volatility in commodity derivatives markets.”

Under the new rules:

nContinuous order-matching system operators provide aggregated order information on liquid shares at the five best price levels on the buy and sell side; for quote-driven markets, the best bids and offers of market makers must be made available.

nPost-trade, firms will be required to publish the price, volume and time of most trades in listed shares, even if executed outside of a regulated market.

nFirms must take what the ESMA calls “reasonable” steps to get best execution for a client, including price, cost, speed, likelihood of execution and likelihood of settlement.

nMiFID will treat systematic internalizers, its term for market-makers, as mini-exchanges, subject to pre-trade and post-trade transparency requirements.

The result, said Mr. Conigliaro, could mean a chain reaction in institutional money management: trading cost increases passed by some managers to asset owners in the form of higher management fees; larger firms eating the increased costs to gain market share; smaller managers, facing such cost competition, being acquired by larger money managers; and decisions by more asset owners to handle fixed-income and derivatives investments internally.

MiFID II “will mean a huge shake-up in the asset management industry,” Mr. Conigliaro said. “It has the potential to drive consolidation in the industry. There'll be a loss of some of the smaller managers without the scale to handle the cost increase in what amounts to a long-term arms race against bigger managers. If those smaller firms have to pass on more cost to the asset owner and thus affect the performance, they'll either cease to be competitive or become targets for larger firms to acquire them. I think the regulations will create an environment where the largest managers will just get bigger.

“Even further, you could see how this tumbling ball could just get bigger,” he added. “If the industry becomes so cost-ridden and passes on more of the costs, you can see why some asset owners would decide to do more internal management. There'd be more Ohio STRS, CalPERS, CalSTRS out there who'd manage in-house. They'd see it as more effective to manage fixed income themselves.”

Steven Glass, president and CEO at Zeno Consulting Group LLC, Washington, a boutique consulting firm that monitors trading issues on behalf of asset owners, said that it's “very early days” for owners to contemplate whether to manage non-equity assets internally, because many aren't as knowledgeable about fixed-income transaction costs as they are with equities.

“Equity transaction cost analysis is a much more mature area,” Mr. Glass said. “With fixed income, asset owners generally aren't there yet. It's the first inning of a baseball game that's going into extra innings.”

Mr. Glass said about a third of his asset-owner clients with a question on equity trading costs would call their money managers. “They're nowhere close to that comfort level on bond trading yet,” he said.

“For large U.S. pension funds and other asset owners, for the portion they have in European equity and fixed income, will the endgame of these rules be good or bad?” asked Per Loven, head of international corporate strategy, Liquidnet Europe Ltd., London. “The changes will inevitably raise transaction costs. Net-net, that will mean a drag on performance, and that's a negative. How much of a drag is hard to say.”

The ultimate result of MiFID II will be a move to trade fixed income on electronic venues, said Anthony J . Perrotta Jr., principal and head of fixed-income research at TABB Group Inc., New York. “MiFID II boils down to an upgrade to the fixed-income (trading) infrastructure,” he added. “This amounts to a little gentle persuasion by ESMA.”

Henry Yegerman, New York-based director of trading analytics and research at Markit, warned that MiFID II could put over-the-counter markets on the critical list. “Those regulatory changes will starve the OTC markets” as they are replaced by systematic internalizers — ESMA's term for traditional market-makers — “which will be large sell-side firms that will internalize trades and provide liquidity.

“They won't formally kill them, but it will be like taking a goldfish out of a bowl and leaving it outside,” Mr. Yegerman said. “It won't get oxygen and will die. That's what'll happen to OTC markets.”

Scot Warren, Chicago-based executive vice president, business development for Options Clearing Corp., said the death of OTC markets isn't “a preordained outcome. Those over-the-counter markets are evolving to meet regulations but also to meet the needs of the buy side and the sell side. The impetus is toward centralization, but if OTC trading can meet the needs of transparency, changes won't close all avenues to OTC.”

Critics like Zeno's Mr. Glass warn that European regulators are forcing the round pegs of non-equity trading into the square hole of stock-market structure.

“I don't think you can apply all elements of equity market structure to other securities,” said Jamie Selway, managing director and head of electronic brokerage at Investment Technology Group Inc., a New York-based financial markets technology provider and dark-pool operator. “I don't want to accuse MiFID II, but as a general matter, given the differences among securities in how they're margined, how they're financed and their liquidity, it's not a good idea to take principles of equity markets and graph them onto fixed-income and other markets.”

Markit's Mr. Yegerman said now's the time for asset owners to talk with their bond managers about the impact of MiFID II on their portfolios. “Asset owners should talk to their fund managers and find out their views and plans to deal with MiFID II across all asset classes and ask them to query their brokerages on how they plan to address the new regulations. It's too soon to talk about the impact on performance and numbers, but it's not too soon to talk with their managers and counterparties about what this will mean to them.” n