For Whom the Bell Tolls
– Will MiFID II Bring About the End of the OTC Era?
A whole lot of people are currently very busy across the European financial sector getting ready for MiFID II/MiFIR for January 2018. It’s a broad regulatory complex, touching many aspects of the banks’ activities. I imagine that project owners and steering groups – not to mention the project managers and the many project participants – are focused on getting the many deliverables in place, getting the details right and fretting about the lack of legal clarity on important aspects.
By Christian Thygesen, Managing Partner | 28th September 2017
This is certainly the picture I see from the MiFID projects my colleagues and I are involved in.
This, and two subsequent posts however, are not about getting MiFID right and delivered in time – important as it is. Rather, it’s some hopefully not entirely uneducated guesswork as to what we will see as the consequences of MiFID, say five years from now.
The Beginning of the End
My guess is that down the road, when the dust of the minutia of MiFID II has settled, early 2018 will be remembered as the beginning of the end of the OTC markets as we have known them since the early 90’s.
Rightly or wrongly, the OTC markets and their inherent intransparency have been blamed for fueling and propagating the financial crisis.
And so, a central goal of MiFID II is increased transparency, across the board one might say, as MiFID is packed with rules aiming at increased transparency, e.g. in the areas of fees, reporting and the possibilities to conclude bilateral trades outside the limelight of an exchange.
This series of posts have a look at the specificities of three important markets in turn:
Equity, bonds and derivatives.
The Equity Market
The equity market was the focus of MiFID I, implemented in 2007, introducing a light version of a trading obligation for equities.
This trading obligation is significantly tightened with MiFID II. Until now, it was possible to effectively circumvent the trading obligation by trading off exchange, but under the rules of the exchange, reporting the trade to the venue after execution under a so-called manual trade waiver.
Double Volume Cap
Through a mechanism known as the double volume cap, this possibility is effectively shut down. The volume cap of course goes for all of Europe, but will hit the Danish equity markets particularly hard.
The tradition of Danish banks to let their customers trade against the book of the bank through a system known as “strakspriser”, means that a high share of the retail trading volume in Danish shares takes place off exchange and conversely a low volume is traded on the exchanges and MTFs.
Added to this, the Danish markets have a share of dark pool trading more in line with the European average. Would this pattern persist after January 3rd, 2018, the double volume cap would kick in almost immediately and all C20 shares would be barred from off-venue trading by the end of January 2018. (Note that large trades could still be traded OTC benefitting from the Large in Scale waiver).
Handling the Retail Flow
This leaves the bank with a limited set of options for handling their retail flow. The simple choice is of course to channel their retail flow to the trading venues, thus directly fulfilling the goal of the regulators:
To move trading onto the exchanges.
The Need to Defend the Current Trading Revenue
This however, comes at a cost: Banks simply channeling their flow to the exchange would lose the spread they currently gain by having customers trade against their own book.
If they wish to defend their current trading revenue and continue trading against their own book, they will become a so-called SI – a Systematic Internaliser.
Becoming an SI – Systematic Internaliser
The SI phenomena existed under MiFID I but was mostly a label without much content. MiFIR changes this and introduces SIs as a new type of “execution venues”.
Becoming an SI will allow the banks to continue acting as they do today, but in return, they will be regulated a little as an exchange (and must pay a fee for being regulated), and among others being obliged to publicly disclose pre- and post-trade prices as well as best execution statistics.
At the core, they will be forced to display actionable prices, albeit only up to quite limited trade sizes, namely the so-called SSTI (Size Specific to the Instrument) which for shares will only be €10.000.
The Burden of the SI and the Danish Banks
A year ago, I would have guessed that less than a handful of Danish banks would have wanted to impose the burdens of the Systematic Internalisers on themselves, preferring to direct their flow to exchanges or other SIs.
This belief was fueled among others by the launch of the so-called “Auction on Demand” (AoD) by Nasdaq, the primary exchange for Danish shares.
Introducing “Auction on Demand”
This new functionality virtually guarantees the exchange member to trade against themselves but on the exchange, and so the banks can continue to effectively execute customer orders against their own book, albeit legally speaking on the exchange.
The on-exchange trading fee for using the AoD is less than the fee for publicizing your off-exchange trades, so more than just circumvent the SI-issue, the banks would generally save money by executing their equity trades in this fashion.
The Continued Trade on Own Books
None the less, so far, the AoD has apparently proven less attractive to market participants than I expected, possibly because it does not immediately allow for evening trading.
Although off-hour trading volumes in strakspriser today are quite low, losing the possibility may have swayed some banks to continue taking the trades on their own books.
Whatever the background for the individual banks’ decisions, currently I believe all, but one or two Danish banks, offering “strakspriser” and trading Danish equity against their own book today, will continue to do so under the new rules.
The Change into Systematic Internalisers
If so, the impact of MiFIR on trading patterns in Danish equity, at least from the retail perspective, will be limited to formally changing the larger Danish banks into what they have de facto been for quite a while: Systematic Internalisers.
On the wholesale market, the jury is still out, but my guess is that we will see some of the dark pool trading moving towards closed on-exchange auctions.
In sum, MiFIR may end up having a relatively modest impact on trading patterns in the Danish equity market, if not for any other reason than because the equity market is the model that the regulators seem to have tried to emulate for the other asset classes.
Christian Thygesen, managing partner
Christian Thygesen has been employed in the financial sector since joining the Danish Central Bank in 1992. From 1998 to 2002 he worked for the European Central Bank in Frankfurt, dealing first with financial infrastructure monitoring and then monetary policy in the office of capital markets and financial infrastructure. From 2002 to 2007 he was Head of Projects & Analysis at Roskilde Bank.
Since then he has worked as a consultant in the capital markets area with focus on efficient implementation of regulation and system selection in its many guises.
You can read more about Christian and our other CMP consultants here.