What Is MiFID and Why Should I Care?

Hotshots at the European Commission finally turned over their homework and released a list of proposals to polish the Markets in Financial Instruments Directive (MiFID) law. Some are pretty impressed with their efforts to regulate the markets, but naysayers think that there’s still a lot of work to be done.

Before we get ahead of ourselves, let’s first talk a little bit about MiFID.

A couple of years before we were introduced to the awesomeness of the iPad, European officials were pretty lax about the regulation of the region’s financial services sector. However, when the 2008 financial crisis hit, the need for tighter regulation arose. Markets in Financial Instruments Directive or MiFID was created to address issues of poor methodology, consultation, and transparency in overseeing the sector.

MiFID is a harmonized law crafted by the European Union to regulate financial activity among member states of the European Economic Area. Since the initial report had a lot of issues, policymakers took it among themselves to consult the public for suggestions and incorporate them in the new and improved MiFID II.

Here are some of the changes included in the revised proposal:

First is the regulation of Organized Trading Facilities (OTFs) or systems that compile buy and sell orders of financial instruments. Previously, the EU only kept tabs on multi-lateral trading facilities (MTFs) or entities that enable multiple parties to conduct transactions. But since OTFs are starting to play a big role in the markets, officials have outlined a list of rules to promote transparency and eliminate conflicts of interest.

Algorithmic trading, characterized by the use of computer programs to execute trade orders, is also subject to further regulation. Why?

Officials want to minimize the risks posed by high frequency trading (HFT) which is one of the more popular forms of algorithmic trading. You see, in HFTs, trading systems analyze markets and enter orders (which are oftentimes very large) at superfast speeds. To minimize the volatility brought about by algorithmic trades, order-to-transaction ratios under MiFID II are limited. Officials also think that by requiring algorithmic traders to trade on a continuous basis, trading will be more orderly.

MiFID II also grants power to regulators at the European Securities and Market Authority (ESMA) to ban people or practices that they consider a threat to the stability of markets. Officials are tasked to take necessary steps against market participants who trade extremely large positions.

Finally, in an effort to protect investors, MiFID also sets stricter requirements for portfolio management and investment advisers. For instance, independent advisers won’t be allowed to give out and receive payments from third parties to eliminate conflicts of interest.

As with any changes in law, this directive has its advantages as well as its disadvantages. Let’s start with the good stuff first, shall we?

The good news is that market junkies think that the directive will increase transparency in the markets since it would migrate all trading activities to regulated market operators, namely: multilateral trading facilities (MTFs) and organized trading facilities (OTFs).

However, the not-so-good news is that some parts of the proposal are still very vague. For instance, it doesn’t give a clear-cut definition of an OTF, prompting several forex dealers to be concerned that the unique attributes of the forex markets might be overlooked.

Aside from that, naysayers were quick to point out that the regulations were weak and will not do enough to encourage stability. They also criticized the fact that firms will also have to worry about paying for substantial costs for transactions and trade reporting requirements that the regulation will impose.

These are just some of the things that the European Parliament will need to take note of and debate about before turning the proposed regulation into law. European member states will also have a say in the review in order to make sure that the regulation will soon restore faith in the capital markets. Bear in mind that failure of the policymakers to properly define these regulations could do more harm to the industry than good, so… No pressure!