On the regulatory front, a handful of new policies are set to affect the options market and will likely enhance transparency, execution, and market data. Meanwhile, the cash equities business has hit a level of maturity and we are now trending toward better tools for block crossing and less resource intensive methods of trading.
In this interview from the Winter 2012/13 issue of Best Execution Magazine, Jim Cochrane talks about the challenges of achieving best execution in the FX market. Learn more
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: http://europa.eu/rapid/press-release_MEMO-14-15_en.htm?locale=en).
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!
The unbundling of research and trading has been a discussion topic for many years both globally and in Asia. While in theory there are many good reasons to unbundle, the practical implications have often made it difficult for asset managers to do so. However now several important business factors are pushing Asia-based fund managers to review their processes and consider how they value research and trading, while using more sophisticated tools to manage and report on who and what they pay.
Asset owners and regulators demanding more transparency from fund managers
It’s no secret that recent years of lower Asian equity turnover and compressed commissions have placed pressure on buyside firms to review the value of services they receive from brokers. However, demand for more accountability and transparency in this area is now also coming from other, arguably more important, angles.
As global funds invest more in Asia, mandates from asset owners to the fund managers come with global requirements – increasingly this includes best execution policies and reports on the use of brokerage commissions. In particular more fund mandates, particularly those from US or UK based pension funds or sovereign wealth funds, may ask for a breakdown of how much commission has been generated by their fund, and how that was spent. Asia-based asset managers who cannot demonstrate clear processes and reporting to their clients on how they select and what they pay their trading and research providers could miss out on winning or retaining mandates.
One of the reasons the mandates are changing is because of increased awareness among those asset owners of best execution regulation – which is now mandatory in many markets – and also corporate governance best practice around how brokerage commissions are used. For example the UK FSA (now FCA) in November 2012 published a review of conflicts of interest for UK asset managers which included the comment: “Firms regularly spend millions of pounds of their customers’ money buying research and execution services from brokers. Only a few firms we visited exercised the same standards of control over these payments that they exercised over payments made from the firms’ own resources.”1 This scrutiny has triggered a review of procedures by many fund managers, reinforcing a focus on this principle which is already written into voluntary codes of conduct for investment managers around the globe, from the US to Australia and many countries in between.
With client and regulatory review growing, the knock-on impact is global: initially the effect on Asia-based asset managers is perhaps most direct on those who have operations across multiple regions – and particularly those with significant UK connections where regulatory scrutiny is highest. However, as with any free market, as those firms raise the bar on the transparency they can deliver to clients, others will need to follow to remain competitive.
Putting the theory into practice – growth of CSAs and CSA aggregation
As these buyside firms look at client and regulatory demands for transparency, there is now a growing trend to have consistent best practice by using a model that will work across different regions. Typically this means applying a ‘highest bar’ approach where the region with the most stringent requirements is taken as the benchmark. The effect for Asia is that, despite little local regulation for fund managers in this area, for commercial reasons the same policies and internal procedures are likely to be applied when it comes to selecting and paying brokers.
Commission Sharing Arrangements (CSAs) are widely used as the mechanism to enable a more transparent approach. With overall adoption rates of commission management programs estimated at over 83%2 in the UK and 76%3 in the US and seeing year on year growth, it is no surprise that CSA adoption in Asia almost doubled from 2011 to 2012, from 22 to 43%4.
As the use of CSAs becomes more prevalent, this has also resulted in the development of CSA aggregation in Asia, led by ITG. This is a service whereby fund managers trade and build CSA credits with their existing CSA brokers, then to simplify the management and administration of the system, those credits are reconciled and pooled centrally by the CSA Aggregator. This reduces workload for the fund manager by outsourcing the time-consuming reconciliation process, and creates a single CSA balance from which to view and manage all payments.
An essential component of this service in the current environment is that it can be used to provide detailed analysis and reporting of commission spend, allocation by research type or provider, and do so in a way that can deliver reporting at an individual fund level, or within a framework that takes into account different global rules on CSA eligibility.
The multi-million dollar question…
Having CSAs and CSA aggregation in place does not in itself solve the industry’s challenge of defining how much research is worth – the multi-million dollar question which will ultimately have a different answer at every buyside firm. However it does provide a highly transparent framework for tracking how much is used to pay for execution and research, what is spent, and as a reporting mechanism in a global environment where a fund management firm’s clients, the regulators and the fund management business itself are asking for more transparency and accountability on commissions than ever before.
1. Financial Services Authority: Conflicts of interest between asset managers and their customers: Identifying and mitigating the risks. Section 3.1. November 2012.
2. Celent: estimate for 2011. Source: Commission Sharing Agreements in Asia, The Right Idea at the Right Time?. P11. August 2011
3. Greenwich Associates 2013 survey of US Investors4. Greenwich Associates 2012 survey of Asian Investors
Our analysis of Canadian equities order flow this quarter indicate that HFT activity has scaled back slightly: total order flow reduced, Order-to-Trade ratio decreased, Volume Traded-to-Order ratio increased, and the rate of order activity has slowed down. We also add to the debate over the cost of real-time market data – we describe an objective method to intrinsically value market data using three core factors. How much should market data be valued?