Living in the Post-MiFID II World

February 06, 2014 Juan Pablo Urrutia

On January 14th, Michel Barnier, the European Commissioner in charge of financial services in the European Union (EU) welcomed the agreement in principle reached on rule changes to the Markets in Financial Instruments Directive (MiFID II/ MiFIR).  Barnier declared that although the speed of implementation was not ambitious enough, the agreement still represented “a key step towards establishing a safer, more open and more responsible financial system and restoring investor confidence in the wake of the financial crisis” (see:

Some commentators have described MiFID II/ MiFIR as the European equivalent of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act).  Others also suggest that given Barnier’s penchant for self-described ‘ambitious’ projects, the analogy with Dodd-Frank would suit him just fine.  However, just how ambitious is MiFID II/ MiFIR and what is the timetable for achieving Barnier’s objectives?

Scope of MiFID II/ MiFIR

The main focus of this Blotter is the fundamental change that MiFID II/ MiFIR will bring about to market infrastructure (pre and post trade) and electronic trading. However, the updated legislation will also impact governance aspects of trading venues and investment firms (whether the investment firm is a broker, active or passive asset manager or proprietary trader), the way in which investors are protected (e.g. a considerably tighter suitability and conflicts regime), the extension of the market rules to the non-equities space (derivatives, fixed income, commodities and FX) and rules that govern offering cross-border services into the EU – these are but a few of the myriad of other items in Barnier’s ‘ambitious’ MiFID II/ MiFIR agenda.

However, the extensive list of markets and participants that will now be captured by the long arm of the European law masks a potentially less perfect future for the success of the MiFID II/ MiFIR dossier. Below, we anticipate some benchmarks by which the updated rules could be judged.

Timetable for MiFID II/ MiFIR

The European Commission (Commission) is still working on producing a consolidated MiFID II/ MiFIR text and the availability of the final text will depend on the time needed for the technical meetings that put into words the agreement of the politicians. Despite this process, we still expect MiFID II/ MiFIR to Enter Into Force (EIF) in the first weeks of May but, no later than 1st July in any event.  From this legal implementation date, the clock is then running and the timetable is fixed.

From the EIF date, the European Securities and Markets Authority will have 1 year to draft the respective ‘Level 2’ regulatory standards and 1 1/2 years to draft the implementing standards (this process is similar to the rulemaking performed for the Dodd-Frank Act).

Whilst MiFIR (the regulation) will be directly applicable across the EU, MiFID II (the directive) will need to be transposed into each country’s national law within 2 1/2 years from the EIF date. Only after this step will market participants need to comply with MiFID II and MiFIR.  Given that the EIF is expected to be in July, we expect the MiFID II and MiFIR to come into force in January 2017.

Dark trading in the MiFID II/ MiFIR era

The majority of dark trading in Europe is split across Broker Crossing Networks (BCNs) and Multi-lateral Trading Facilities (MTFs) with trading occurring at midpoint, within the spread and at the touch price.  This model will be fundamentally changed by the introduction of MiFID II.  Brokers will no longer be able to cross client order flow internally within their algo trading businesses as MiFID II requires the closure of their BCNs.  Dark activity in MTFs will also be curtailed by limiting execution prices to midpoint only and implementing caps on the volume that trades in both any individual venue and the overall volume across all dark MTFs.  These caps will be implemented at 4% of the total volume of trading in the overall market for any individual pool and 8% of the total volume of trading in the market for all dark pools in aggregate.  The calculations will be performed at an individual stock level over a 12 month rolling window.  In the event that the relevant cap is breached, the implication is punitive and binary; execution of that stock in the pool or in all dark pools would cease for the 6 month period that follows.

At first glance, the removal of BCNs and touch price execution leaves plenty of headroom under the cap. But the question is what will brokers do to react to not being able to cross client order flow?  But before we consider those responses we need to understand the other main trading methodologies that will be permitted under MiFID II.

Reference Price Waiver (RPW)

This is the methodology under which most dark MTFs operate.  Execution is done at the price determined from another system such as the primary market or the European Best Bid Offer.  Currently MTFs trade at the Bid, Mid and Offer.  After MiFID II, execution will be restricted to the Midpoint only.  This type of dark trading will be subject to the volume caps.

Large In Scale Waiver (LIS)

For very large orders, (stock specific >€500,000 for large cap) a different rule can be employed to operate a dark pool.  This order type has the flexibility to trade at any price point.  Due to the flexibility of the Reference Price Waiver, the Large in Scale waiver has seen relatively sparing use in Europe up until now.  Importantly this type of dark execution will neither contribute to the calculation of the volume caps nor stop trading if the cap is breached.

Systematic Internalisation (SI)

Rather than being dark, this trading methodology is classified as a pre-trade transparent execution as the firm operating the platform has a continuous quoting obligation.  Execution is automatically performed against the capital of the firm operating the SI.  Again, this structure has seen sparing use to date due to the flexibility of the BCN structures which have allowed a broad range of execution.

New venues, new approaches

Rather than brokers just shutting down their BCNs and handing off all order flow to the lit markets, we expect to see the creation of multiple platforms in order to cope with the new rules of MiFID II.  We are likely to see the emergence of new broker operated Dark MTF venues, and, to manage the risk of the volume caps coming into play, we also expect to see extensive use of the other strategies.

For high value order flow, algorithms and execution strategies will prioritise venues (or segments of venues) that use the LIS waiver, allowing execution via blocks that will not be subject to the volume caps.  The wide adoption of this approach by brokers should lead to a small number of successful venues that trade in large sizes.

Given the restriction on trading at the touch price in dark pools, we also expect to see an expanded number of Systematic Internaliser pools to replace this execution type.  That said, this desire to internalise may be offset by higher capital requirements for brokers operating these venues in the future through the introduction of the Capital Requirements Directive IV.

A less likely but also possible outcome is the introduction of one or more broker sponsored lit markets where they would prioritise execution.  Given the broad access to quotes and liquidity, this option may not garner the necessary passive liquidity for the broker to use over the current suite of lit markets.

Fragmentation of dark

The new rules governing dark trading have only recently been confirmed and much of the details remain unspecified.  The operators of dark pools are therefore just beginning to get to grips with the changes they will need to make and are waiting until the rules are finalised before determining their plans.  However, we can already foresee that the number of pools of liquidity in Europe will rise significantly.  Where one pool was able to perform several roles, (blocks, aggregated liquidity, touch price execution) these activities will be fragmented into multiple venues specialised in one type of liquidity.  Through this specialisation, we expect the amount executed by smaller orders at midpoint to be kept to a minimum and for execution to be able to continue under the new volume caps.  An understanding of the full impact of the new rules, however, will require more details, with the calculation logic for the caps being a key detail.  Unfortunately that level of detail is unlikely to be available in the Level 1 text and we will probably need to wait a year or more for the final assessment!

Impact of MiFID II/ MiFIR on electronic trading

The agreed text includes new obligations on investment firms that provide direct electronic access (e.g. DMA services) or use algorithmic trading strategies. Firms that provide direct electronic access will need to have effective systems and controls in place that, for example, stop the trading process if price volatility becomes too high. Although, we will need to await the ‘Level 2’ technical and implementing standards to have full visibility on who will be required to have those systems and controls, we should expect that brokers will be required to comply with this rule rather than the buy side. However, to the extent that the volatility measures required by the regulators are too sensitive, this may also become an issue for the buy side if trading is unnecessarily and frequently halted.

Much of the debate on who is using algorithms will need to be thrashed out at the ‘Level 2’ implementing and technical standards. Arguably, broker operated algorithmic strategies should exempt the buy side from new requirements to test those algorithms and seek notification from regulators to operate those same algorithms. Nonetheless, regulators could create an unnecessary and substantive burden on the buy side if they interpret the ‘use’ of algorithmic strategies to mean economic benefit obtained from, rather than operational control over the algorithm. Although it is widely expected that the notification to regulators of the algorithmic trading strategies employed by investment firms will be nothing more than the delivery of information that can be found on a marketing brochure, we believe that MiFID II/ MiFIR will leave sufficient discretion for national regulators to insist on those notifications becoming regulatory authorisations and on standard marketing brochure information becoming a more substantive demand for source code information. In either case, we query the current readiness and ability of regulators to adequately deal (and borrowing from regulatory language) with the information relating to those algorithmic strategies in a fair and orderly manner.

Breaking the European integrated trading and clearing vertical silos

For the first time Europe’s exchanges that operate under an integrated vertical silo structure will eventually be forced to open up their lucrative integrated crossing and CCP businesses to other exchanges. This change will be most relevant to clients that trade derivatives and we expect that if the rule is fully implemented (note our scepticism), this should bring substantial benefits to clients including a reduction in both trading and clearing costs. However, the change will not happen before a transition and deferral period that could last as long as 60 months.


In effect, for those of cynical predisposition, the agreement gives some protection to the vertical silo model and was one of the key German conditions to agreeing to MiFID II/ MiFIR. However, as reported by the press, ICE’s 4% share price drop the day after Barnier’s announcement suggests that there may still be a certain amount of investor nervousness that the rule may in fact have teeth.

Market Data

One of the emerging failures of MiFID II/ MiFIR is the apoplectic inability of policy makers to agree to stringent process, systems and controls for ensuring that European market data is offered at a competitive price. Policy makers and regulators alike are naively relying on tinkering with the language in the existing regulations to demand that market data will need to be offered at a “reasonable commercial” price.

Since 2007, the existing rules already state that exchanges and other lit trading venues must provide that market data on a non-discriminatory basis. We still cannot understand why regulators think that lit trading venues are going to be scared into unlocking the data market by the addition of a few tokenistic words.

Perhaps, the biggest failure of policy makers in this respect is in their choice to ignore that the market data should in fact be owned by the institutions that cross orders in those lit venues. Hence, those lit venues should not be allowed to treat that market data as theirs and instead should only be entitled to charge a considerably lower fee to cover just the transmission of that data.

Consolidated Tape

The European Parliament and the European Council have agreed with the Commission that the EU’s response to the market’s need for a consolidated tape will be best served by finding a private entity that is willing to publish the post trade information on a consolidated basis.

After a few years of attempting to locate a commercial entity willing to provide consolidated market data services and a prominent failed project (i.e. the independent COBA project set up in 2012 and closed in 2013), we are no further along that goal. Perplexingly, market participants have on a number of occasions raised with the Commission the difficulties in making the data accessible in the appropriate format and at an appropriate cost. However, policy makers in Brussels still think that there is a commercially viable solution – clearly, we can extrapolate from this viewpoint that EU policy makers know markets better than participants!

Alarmingly, the consolidated tape should play a key role in providing a neutral and third party validation system for testing the volume of dark trading for the purpose of triggering the caps mentioned earlier in this Blotter. Yet, the Commission has given itself two years from the EIF to decide if it will mandate the creation of consolidated tape provider. By then, we will be circa 12 months away from the full MiFID II/ MiFIR implementation deadline. In turn, the market expects the creation of a consolidated tape provider to take substantively in excess of an additional two years to build. In effect, EU policy makers may be on a course to having mandated themselves into a corner!

Concluding remarks – the settling of scores

MiFID II/ MiFIR has been negotiated in the shadows of the financial crisis that began with the Lehman Brothers insolvency. In this respect, market participants and policy makers often refer to the G-20 Pittsburgh Summit of 2009 to pinpoint the event that crystallised regulatory resolve to force many derivatives to be centrally cleared and traded in multilateral venues. Equally, we have seen how politicians from the right and the left have used the G-20 Pittsburgh Summit mandate to give respectability and credibility to the introduction of a large number of rules which had very little if anything to do with that summit.

However, we often forget that there always were strong undercurrents that predate the financial crisis and the G-20 Summit. In fact, the market structure aspects of MiFID II/ MiFIR were primarily negotiated against the backdrop of the original MiFID, which brought competition to European exchanges through the abolition of the concentration rules – those rules had forced (until MiFID) all secondary market trading to be executed on the national primary exchanges.

The quid pro quo reached in the original MiFID between the pro-Anglo Saxon model countries (e.g. the United Kingdom, the Netherlands and the Scandinavian members of the EU) and the continental and southern Europeans (e.g. France, Italy, Spain and Portugal) was to limit the amount of trading that could take place outside of lit venues. At the time, the continental and southern European block believed that they had left the negotiation table with an agreement that would primarily require dark trading to take place under the Large In Scale waiver and over the counter trading to primarily take place in Systematic Internalisers – or at least, these are the type of assurances that the national exchanges may have received at the time. The reality has been very different with the predominance of bulge bracket broker crossing systems and the very extensive use of the Reference Price Waiver in dark MTFs.

We would suggest that this is the scene setting, which in many ways, portrays the MiFID II/ MiFIR negotiation process as resembling two episodes of “The Sopranos”, where MiFID I is titled “Dawn-raid on the Club Headquarters” and MiFID II is the episode that will be titled “The Settling of Scores”.

Whilst we would agree that the national exchanges have successfully fended off threats to their continued receipt of rents through the monetization of market data and they should certainly be one of the winners in the push to force derivatives into multilateral trading venues and central clearing houses, we are less sanguine on their opportunity to re-capture the lost trading opportunities after the introduction of the MiFID II/ MiFIR dark trading rules.  At best the activity they seek to disrupt will find its way to other off-exchange venues; at worst it will impact liquidity to the detriment of investors.  We see little likelihood that MiFID II will enable exchanges to recapture market share and instead predict that alternative platforms will continue to grow as more investors find value in their services.



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  • Juan Pablo Urrutia

    Managing Director, General Counsel, EMEA

    Juan Pablo joined ITG in April 2011 to head legal and compliance in the EMEA region.

    Prior to ITG, Mr. Urrutia spent five years at Goldman Sachs in positions including Executive Director leading the cash equities sales and trading team in the EMEA Legal Department and more recently, as acting Co-Head of Government Affairs for EMEA