The Markets in Financial Instruments Directive forged major changes to the European financial landscape. As the financial crisis winds down, U.K. and European Union regulators are looking at the next steps to cover everything from hedge fund regulations to clearing.
Creating one unified financial market in the European Union (EU) is no easy task. Yet, 27 EU countries with differing structures, regulations and market participants have been weaving together those threads and addressing new challenges brought on by the financial crisis.
Launched in 2007, the Markets in Financial Instruments Directive (MiFID) instituted across Europe was designed with the lofty goal of encouraging cross-border trading and integrating European financial markets. Prior to the MiFID initiative, exchanges were country-specific and cross-border trading was a complicated and expensive exercise, which only large institutions and banks could attempt.
Since MiFID's inception, the pace of change has been inexorably - and necessarily - slow. Early gains have certainly been made - there are now alternative trading venues and cross-border settlement capabilities. But much more needs to be done to achieve harmonization. As the market evolves, this becomes more elusive.
Regulators, struggling to address the groundbreaking changes already present in Europe, face additional pressure to accelerate reform due to fallout from the financial markets crisis. A pre-planned look at MiFID and how it is working is already in progress.
Anthony Belchambers, chief executive of the Futures and Options Association in London, says the MiFID review had to change with the times. "The MiFID review was originally going to be 'is it working or isn't it?' Now the lessons from the financial crisis are being imported into the review."
The Committee of European Securities Regulators (CESR) is now considering making additional changes to MiFID to improve supervision and the quality and cost of post-trade data. It has also asked for comment on some of the newer "technology driven" methods of trading such as dark pools, high-frequency trading, sponsored access and co-location of servers at exchanges.
The MiFID review is going on at the same time as a number of regulatory initiatives designed to strengthen the regulatory fabric. The Bank for International Settlements is working on amending its Basel II Capital Requirements Directive, proposing to align compensation with the associated trading risks taken and mandating stress testing for adverse scenarios.
In addition, the European Commission is proposing to better regulate hedge funds and private equity firms with the Alternative Investment Fund Managers (AIFM) directive. The AIFM is causing consternation from non-resident hedge funds that may not be allowed to do business in Europe.
At the same time, there are calls to create a European equivalent of the U.S. Commodity Futures Trading Commission to regulate commodity derivatives and curb market volatility.
Simon Crown, partner and regulatory expert at the law firm Clifford Chance, says that the MiFID review might not be at the top of the major players' agenda at the moment.
"The review is still a priority," he states. "But I'm not sure everyone is as excited about it as they would have been before the crisis."
Crown says the bulge-bracket banks have more important things on their plates "like the changes in capital and liquidity requirements and AIFM. They are wondering if certain business lines will become too expensive to keep."
Since MiFID went into effect, European financial markets have undergone a fundamental restructuring, with pan-European trading, consolidation among exchanges and new clearing arrangements.
Clearly there is a lot of work to be done to enfold and supervise these trends and structures. CESR, one of the three Level III committees of the European supervisory authorities, will become much more powerful as a result. In the near future, CESR will become the European Securities and Markets Authority, with a larger staff, new standing committees and more supervisory powers. By the end of this year, Belchambers says, CESR will be able to compel member states to comply with regulations. This is not going unchallenged.
"Member states recognize the importance of common standards but some - the U.K. in particular - are nervous about conflicts regarding supervision," Belchambers says.
Quest for interoperability
Post-trade issues are an important concern for European regulators. Clearing and settlement remains fragmented and challenging, despite the European Union and clearing industry's 2006 Code of Conduct agreement to cooperate in clearing and sharing data. To help address this, the European Central Bank launched its own technology initiative last year, Target2 Securities, to build a pan-European securities settlement platform.
The theoretical savings of interoperability have yet to transpire.
"The Code of Conduct should have decreased post-trade costs and made it possible for a financial firm to work with one central counterparty clearing house for all their equity transactions on a pan-European basis," says Axel Pierron, senior vice president at Celent in Paris. "The reality is that it is very difficult to implement."
Key to CESR's MiFID overhaul is post-trade transparency of data and the ability to effectively consolidate it from multiple European equity markets. To this end, CESR aims to keep the current framework but also introduce formal measures and standards.
"There are different risk management parameters on each system, mainly in how collateral is managed and calculated," Pierron says. As clearing houses in Europe, as well as in the United States, are being encouraged to take on more risk, tensions increase, Belchambers says. He adds that interoperability can actually increase risk if larger, well-funded clearing houses take on risk from a smaller clearing house with less funding. Each of the linked clearing houses could be subject to the failure of another, effectively eliminating the safeguards that contain or limit such failures.
In June, the European Commission plans to launch an initiative to focus on clearing houses taking on significantly more risk going forward. Called the European Market Infrastructure Legislation, it will seek answers to questions over conflicts of interest, governance and how to capitalize clearing houses properly.
"Clearing houses are becoming systematically important," Belchambers says.
Over-the-counter (OTC) derivatives are also a hot-button issue. The battle over regulating OTC markets is long and loud, and is being heard on both sides of the Atlantic. One side of the debate is angling for them to be cleared as part of any regulation while the other cites higher costs and the unsuitability of certain complex, and often illiquid, products for clearing. The CESR is looking to find a graduated risk-based approach between complex and non-complex instruments, which may help ease the pain.
Pierron is not sure a mandate for central clearing is inevitable for all OTC markets.
"There is a huge amount of lobbying by the clearing houses, which have been able to demonstrate during the worst of the crisis that the markets they were operating in have continued to function very effectively," Pierron says. "But there are obvious economic interests as well from the clearing houses to favor regulations that would impose clearing on all OTC markets."
But those costs involved in clearing might jeopardize the economics of some OTC markets. Additionally, margin requirements on cleared trades would take capital out of the financial firms' pockets. There are also end-user costs stemming from having to meet daily margin requirements.
"There is also the fear that if capital rules go up, the clearing houses will pass on the costs to end users. They may have to abandon complex contracts for OTC deals," Belchambers says.
A full draft proposal from CESR is expected by the end of the year, when it will go to the European Parliament. The question then is, will the threads come together to create a strong market fabric?