Introduction
Efficient distribution of resources is very important in financial markets and this can be achieved by implementing efficient and effective regulations. Before the global financial crisis, the rise in the number of investors and proliferation of investment instruments called for the regulation of investment activities. In this framework, the Markets in Financial Instruments Directive I (MiFID I) was introduced on 1 November 2007 with a view to establishing a single market in the EU, protecting investors, enhancing transparency in the markets and achieving integration within the Union. The Directive did not only expand the scope of the previous regulations but also allowed investment companies to operate in host EU countries on the basis of the authorization they received from the home country with minimum additional conditions.
MiFID II Arrangement
After the global financial crisis, there emerged a need to make amendments to the MiFID I regulation. In this context, the European Commission has prepared the Markets in Financial Instruments Directive II (MiFID II). The MiFID II regulation was transposed into the national legislations of EU countries by 3 July 2017. The Directive, which took effect on 3 January 2018, aims to further integrate EU financial markets, protect individual investors and increase transparency for all market participants. The Directive expands the scope by adding bonds and derivatives transactions alongside stocks, and introduces restrictions and regulations relating to over-the-counter markets and financial instruments traded on these markets. The main topics covered by the Directive are: reporting of transactions of financial instruments, keeping all kinds of communication records related to transactions, separation of fees paid for investment research, and issues concerning dark pools[1], high frequency trading (HFT) and commodity derivatives. Banks, institutional investors, organized markets, brokers, hedge funds, investors conducting high frequency trading and trading platforms other than organized markets are addressed in this Directive.
MiFID II directive aims to increase transparency for all market participants. In this respect, the directive brings an obligation to disclose information on all kinds of transactions carried out by financial institutions covered by the Directive and the prices of these transactions. The directive also stipulates that a record of all means of communication, including phone calls, shall be kept for these financial transactions. As per the Directive, records of communication with customers on all financial transactions shall be preserved safely for five years and the records shall be accessible to the regulatory authority. Thus, increased transparency and competition is expected to help investors attain the best prices. It is estimated that financial institutions will incur a total cost of USD 2.1 billion during the compliance process regarding the reporting obligations[2].
The new Directive introduces restrictions on the use of dark pools that became widespread after the MiFID I period. Accordingly, stocks, whose ratio of dark pool trade volume to organized market trade volume reached 8 percent in the previous year, will not be allowed to be traded in the dark pool.
Moreover, each dark pool platform may have up to 4 percent of the transaction volume of stocks traded on the organized market. Currently, institutional or individual market participants can make transactions in dark pools without disclosing their identities or the details of their transactions. Institutional investors in particular prefer these platforms for their high-volume transactions, making it difficult for HFT investors to detect block transaction orders. Nevertheless, the MiFID II directive sets forth some changes for HFTs allowing supervision of financial institutions and market infrastructures that perform algorithmic trade. In this framework, the HFT transaction data shall be reported to local authorities; the algorithms used must be recorded and tested.
Separation of fees for research and investment services is among those changes intended to increase transparency. The rationale behind the change is that there are concerns that if the fees are presented as a single package, the investment company may deviate from the principle of acting in favor of the customer. However, there are also those who expect the fee disintegration to lead to a decrease in research. According to various studies[3], research expenditures are expected to decrease between 10-30 percent and the companies that will be most severely affected would be the ones providing medium-scale research.
In response to the increasing number of non-financial institutions investing in commodity derivatives, the G20 Finance Ministers and Central Bank Presidents recommended in the Communiqué issued after the meeting on 15 April 2011 that participants in commodity derivatives markets shall be subject to regulation and supervision and exceptions shall be reviewed. In the framework of this recommendation, in addition to the arrangements aiming at preventing volatility in commodity prices, the Directive stipulates requesting information from those conducting commodity derivative transactions about the amount and purpose of the transaction and giving the authority to countries to decrease derivative positions when necessary. Moreover, the derivative transaction positions are limited by a specific methodology.
What Are the Possible Impacts of the Arrangement?
As MiFID II introduces limitations and disclosure obligation for securities traded on non-regulated markets, it is expected to reduce the transaction volume and market depth in the EU markets. Particularly, the operations carried out in the dark pools are foreseen to shift to other platforms that are not subject to supervision. It is estimated that the regulation will bring more regulatory differences between the UK and EU legislation, therefore, London, where dark pools are very common, will be negatively affected.
Meanwhile, it is also estimated that banks operating within the EU will decrease their research budgets and staff. Another possible outcome is that increased competition can support independent investment research companies. However, it is likely that financial institutions serving foreign investors in emerging economies will be affected by the regulation and they will bear additional reporting obligations. Therefore, it would be important to closely monitor the impact of the regulation in the near future.
[1] The dark pools can be defined as securities trading platforms that are not open to the public and that have a relatively opaque disclosure structure.
[2] https://www.markit.com/Product/File?CMSID=a8427504afcd46f5acb721d21daed493.
[3] Oliver Wyman, 12 September 2017, “Research Unbundling”; PWC, September 2016, “The future of research: impact of MiFID II on research for investment firms”.