The jury is still out on the question of whether steps to create a single European market for investment regulation and financial services will be a revolutionary Big Bang, or just a damp squid. But one thing is clear: when it all becomes a reality later this year, many banks simply will not be ready.
The Markets in Financial Instruments Directive (MiFID) is the cornerstone of the European Union’s Financial Services Action Plan and will transform the way in which EU financial markets operate. It will create a single market and regulatory regime for investment services across the European Economic Area, which is the EU plus Iceland, Norway and Liechtenstein.
The directive has three core objectives: to complete the process of creating a single EU market for investment services, to respond to changes and innovations that have occurred in securities markets, and to protect investors by making markets deeper, more competitive and more robust against fraud and abuse.
The big benefit for financial firms is that once they have been authorised to do business by their national regulator, they can use a MiFID ‘passport’ to provide services to customers in other EU member states. This means all investment banks, portfolio managers, stockbrokers/broker dealers and corporate finance firms will be able to provide cross-border services and establish branches without restriction. These services will be regulated in their home state, rather than the member state in which the service takes place. This means fewer regulators, and fewer rulebooks, to deal with.
There is also an opportunity for some large pan-European banks and investment firms to gain new business by becoming “Systematic Internalisers” – to use the jargon of MiFID – which means that those that have a large flow of client orders will be able to match those orders internally, rather than taking them to a stock exchange. Several banks have announced plans to join together and form their own exchange once MiFID goes live, which could undermine existing exchanges, if successful.
If those are the carrots, there are big sticks, too. Firms will have to categorise their clients as ‘eligible counterparties,’ professional clients, or retail clients and show they have processes in place to assess their suitability for each type of investment product. There are also new rules on the information that banks have to collect when they take client orders so that regulators can ensure that a firm is acting in a client’s best interests. There are other measures aimed at making sure firms do the best for their clients.
The deadline for MiFID implementation is November of this year, but a recent study from Handysoft, a provider of business process management software, suggests that almost two thirds of European financial institutions do not expect to be ready in time. Even in a leading financial centre such as the UK, where financial institutions are in a relatively more advanced state of preparation, nearly a third are unlikely to comply in time.
On a positive note, the research highlighted that one in ten European financial organisations see “a great deal of overlap” between their MiFID implementations and other compliance tasks that they currently face, and a further quarter were discovering “a fair amount of overlap”. But that wasn’t the case for the majority.
These findings indicate a growing polarisation of financial firms into those using compliance as a platform for wider business process improvement, transparency and competitive reform, and those who regard compliance as a one-off ‘box-ticking’ exercise, the survey concluded. This could result in the competitive gap widening further between leaders and laggards in the European financial services industry.
“Many compliance preparations are behind schedule but it is not advisable to play a waiting game, as non-compliant firms could potentially lose business and attract regulator-imposed penalties, from fines to suspension of trading,” says Wendy Cohen, Sales and Operations Director at Handysoft. “But it is reputational damage which financial firms have most to fear, as the market is increasingly defined by reputation and customer service.”
Cohen says the IT implementation that supports MiFID compliance has become an increasingly major element of an investment company’s competitive differentiation. “Firms must seek to automate compliance processes, without which it is virtually impossible to prevent costs escalating to unsustainable levels,” she explains. “Importantly, utilising appropriate technology solutions should provide a valuable opportunity to explore areas of overlap with other business processes and turn the apparent burden of MiFID to wider business advantage.”
Yet to identify
However, the reality is that nearly two-thirds of financial services firms have yet to even finalise a budget to meet the cost of MiFID compliance. A survey published by software company SunGard found that 65 percent of firms either have no overall plan or are yet to fully identify MiFID-related budgets. However, despite this, general confidence remains high, with 80 percent of those questioned feeling that their firm remains on track with its MiFID preparations. The survey also revealed that of those respondents that had indicated making MiFID budget provisions, 50 percent have allocated less than €1m, while 18 percent have budgeted between €10m and €40m.
Overall opinion remains mixed as to whether MiFID is a good thing for Europe’s economy and there even seems to be a hardening of opinion against the directive. In the SunGard survey, 31percent thought that MiFID would not be in the European economy’s interests over the next five to ten years, 33percent were unsure about its effect, while 36percent thought that it would be good for the economy.
“We are on track with MiFID implementation, but there are several open questions about how the directive will be implemented that we are working on clarifying,” said Pablo Orbiso, Vice President at Citigroup Global Markets Limited, who participated in the survey. Citigroup has set aside a significant sum of next year’s budget to implement any MIFID related changes in order to adhere to the new rules by November 2007, he said. The forecast considers costs such as technology changes, training, legal and compliance. “Overall, we are viewing the project favourably because although it will have significant costs, the main benefits will be to simplify and unify the trading environment across Europe…that is, as long as the national regulators have a unified and consolidated interpretation of the key MiFID rules”, he concluded.
However, Sheena Kelman, Head of Dealing at Martin Currie Investment Management in Edinburgh, offered a different viewpoint: “The timing, for an automated solution, is getting very tight. Companies are unlikely to waste huge amounts of resource on final processes and systems, until the requirements are clear,” said Kelman. “The industry generally needs about an 18-month lead time to make really major changes to their processes. Unless the MiFID deadline changes, or the proposals are relatively straightforward, then the nearer we get to November 2007 the less likely it is that, however willing it is, the industry will be able to comply.”
Richard Thornton of SunGard Consulting Services said MiFID’s impact on Europe’s equities trading landscape is now beginning to emerge. “Although it is encouraging to see that most firms remain confident about preparations, it is also interesting to note that many are yet to commit significant budgets,” said Thornton. “For many, there seems to be an attitude of ‘wait-and-see’ as MiFID’s implications become clearer over time.”
Indeed, it is one of the peculiarities of MiFID that the EU went into the project without doing a full cost benefit analysis of the changes. Last year, the head of the UK Financial Services Authority, Callum McCarthy, suggested that the costs of introducing the changes might outweigh their likely benefits. “Whether the benefits for Europe as a whole outweigh those costs, it is impossible to say because no proper (cost-benefit analysis) has been done,” he told a parliamentary committee. “I think it is deeply unsatisfactory that we should be in that position.”
Since then, the FSA has published its own analysis, which appears to confirm those worries. The study, by Europe Economics, the consultancy, indicates UK businesses will spend £1bn to implement the directive, but will see net benefits of only about £100m a year.
However, other analysts have painted a more upbeat picture. LogicaCMG, an IT services company, published a report entitled “MiFID – An Opportunity for Profit” that outlines three industry scenarios post November 2007. “As with other legislation, more can be made of MiFID than just regulatory obligations,” says Lode Snykers, a director in the financial services arm of LogicaCMG. “There is an opportunity for growth and for profit. This is not to downplay the practical challenges of compliance – these are considerable and firms need to act now to turn clear strategies into practical action. This includes the management of processes, data and communications that are needed for pre and post trade transparency and compliance.”
Report author Graham Bishop, an independent consultant, says that the pace of technological progress continues to be so rapid that the cost of compliance may not be as high as feared. “Critically, the marginal cost for individual banks in becoming a Systematic Internaliser may be lower than many banks expect, so many more SIs may emerge than are currently expected,” he says.
The report outlines three scenarios that focus on the rise of Systematic Internalisers versus the potential decline of stock exchanges. Under the first scenario, the status quo continues. The policy objective of cutting trading costs is achieved in relation to exchange fees, but the failure to complete all the flanking measures frustrates the ambitions for broader competition in trading securities. Indeed, the exchanges remain comfortably profitable and are able to invest in new technology themselves, so they keep their economies of scale versus any competitor.
Under the second scenario, Systematic Internalisers become private, global stock exchanges operating vertical silos. The firms that took a bold view on becoming Systematic Internalisers turn out to gain such a major competitive edge that they reduce to a handful. In effect, they become vertically integrated, global stock exchanges. But they are privately owned and span several regulatory regimes.
The third and final scenario sits part way between these extremes. But this is unlikely to be a stable position in the longer term, as some of the stock exchanges will find the competition increasingly hard, especially if they do not have a derivatives business. The tipping point could come if a listed stock exchange decided to split off its stock exchange business and preserve the high-growth derivatives profits so as to maintain the premium rating of its shares, the report says. “Then the slide towards private stock exchanges in liquid shares would be underway.”
To date, MiFID has been a story of heavy compliance costs incurred for the sake of elusive and uncertain benefits. If financial firms are to do the work necessary to comply in time, those benefits are going to have to become more tangible.