Prizes for pioneers? How MiFID could reshape European capital markets and institutions

Citation

Gentle, C. and Neasham, J. (2006), "Prizes for pioneers? How MiFID could reshape European capital markets and institutions", Journal of Risk Finance, Vol. 7 No. 4. https://doi.org/10.1108/jrf.2006.29407daf.002

Prizes for pioneers? How MiFID could reshape European capital markets and institutions

The regulatory assault course experienced by major financial institutions over recent years has thrown up yet another major obstacle. Ensuring fatigue does not inhibit the adaptation of risk and business processes this time around will be critical to maintaining the future health of a financial institution – the prizes are likely to be taken by energetic pioneers.

The European Union's (EU) Market in Financial Instruments Directive (MiFID) is acknowledged as one of the most significant shakeups of the European financial markets in a generation. It aims to create a single market and regulatory regime for financial services within the EU. Unlike other corporate governance legislation, MiFID goes beyond raising internal standards it also promises to transform the way that financial markets in Europe operate. Traditional roles in the investment markets will change and, in some cases, disappear. But new roles will emerge along with opportunities for firms to expand into new areas and with the right technology new innovation should accelerate.

It is expected that MiFID will come into force in November 2007. Finance sector companies across Europe are already planning for the administrative and technological changes that will be required. The biggest direct change for many firms will be to upgrade IT systems to satisfy the more detailed requirements for data history, records management and enhanced transaction processing.

One of the key changes under MiFID is the extension of regulated share trading beyond traditional exchanges. Firms frequently dealing on their own account by executing client orders will be able to register as Systematic Internalizers (SI) just like an exchange. These SIs will also be obliged to report to the market the same trade information to the market currently required of exchanges. MiFID mandates, for example, that pre-trade quotes and post-trade prices will be publicly available on a near real time basis. Firms will be obliged to provide clear audit trails for transactions and demonstrate that they have provided "best execution" in accordance with their client agreements. This may become a significant technological challenge given "best execution" would not always be the best price as other factors such as timeliness and specific venues will also need to be considered.

Those who take on the role of SIs will, therefore, need to re-engineer their IT support systems both to capture and to provide access to transactional and price data. There is currently much debate in the industry about how many firms will emerge as SIs across Europe. Expectations range from 20 to 200 firms but the reality is that it is very difficult to determine whether or not this is going to be an attractive proposition for many.

The fixed costs of being an SI are not insignificant, and can be justified only if firms provide deep liquidity and are able to process large volumes of business. Liquidity can be fickle and move from trading venues quickly while the back office processing capability will typically have a fixed cost. The cost estimates to the industry vary significantly depending upon the number of SIs with some analysts estimating that firms will spend between 3.5m and 35m each.

This leads us to our first observation, which is that although MiFID will be treated as a mandatory regulatory program a business case is still required to ensure an appropriate level of senior management engagement and an appropriate budget is secured to support the corporate strategy. The introduction of MiFID and the ability to "passport" products and services into other jurisdictions will open up new revenue opportunities so long as they are embraced early enough in the process.

The next imperative is strategic planning. Implementing the policies, procedures and systems needed for MiFID compliance will involve different challenges for each type of financial services activity. Preparing operations for compliance will encounter separate issues from those faced when implementing MiFIDs requirements on stock-broking, asset management, and the provision of personal investment advice.

All these businesses operate in changing markets so managers need to understand what that means for each business unit. This involves technical analysis of each operation and an acceptance that, despite the comprehensive aims of the MiFID initiative, one size really does not fit all. Strategic planning also means engaging with managers across the institution and ensuring that they are accountable under a proper structure. This will be a significant undertaking in a large organizational structure, in particular those that decide to become and SI.

Another important area is the creation of the design authority for the project. This should be established at the earliest opportunity and driven from the very top of an organization so that the changes to governance structures, polices and procedures, systems, and controls align with the corporate strategy of the firm. It should involve a steering group made up of representatives from senior management, technical support, compliance, operations, risk management, and internal audit. The involvement of each department needs to be proportional to the size of their task. Early strategic analysis could identify where the biggest organizational challenges exist and resources and lines of command can then be put in place accordingly.

Consideration should be given to how other projects in an organization are going to interface over a period of time. All work-streams under the MiFID initiative should be identified from the outset and given timelines. For global companies with a multitude of regulatory authorities to satisfy, this becomes ever more complicated. The challenge is to be consistent in how they treat their clients and this can involve lengthy discussion.

One vital lesson learned from Basel II is that such organizational change cannot be handled in a partial, narrowly focused way without an enterprise remit. Rather, it should have the full backing and engagement of top management.

Those firms that mobilize early, secure engagement with senior management, and respond with an approach that support the firm's corporate strategy will stand a better chance of gaining the prize of a competitive edge in a post MiFID environment.

Chris GentleDeloitte, London, UKJohn NeashamDeloitte & Touche LLP, London, UK