MiFID II: How to capitalise on the creative destruction of the status quo
As MiFID II looms large, swathes of the markets for financial instruments are being completely remade.
MiFID II: How to capitalise on the creative destruction of the status quo
By Christian Lee, Debasree Bhattacharya, & Damon Batten
Business models and profits are under threat and moving to the regulators’ desired future state is likely to be painful and costly. Once the dust has settled, the way certain markets function may be unrecognisable, with clear sets of winners and losers.How should dealer banks deal with this? Let’s tackle the bad news first.
As a direct consequence of MiFID II, banks will find a significant slice of client execution business difficult, if not impossible, to retain.
MiFID II greatly extends the scope of regulation over instruments and execution methodologies. Those offering client execution through any system not currently regulated as a trading venue, or operating Multi-lateral Trading Facilities (MTFs) involving discretionary or non-discretionary trading processes, all face considerable new pressures.
Previously bilateral markets and instruments are likely to transition onto either MTFs or OTFs (the new Organised Trading Facilities). US experience already shows that the operators of such new venues (broadly equivalent to SEFs) are unlikely to be the dealer banks.
Unless banks push hard to build their own MiFID II compliant venues, they will lose much of this business.
Dealer banks who choose not to establish an MTF or OTF but still wish to offer access to their bilateral trading systems need to consider whether they will be classed as a Systematic Internaliser (SI). Even those who successfully establish themselves as an SI will face increasing restrictions on the instruments they can trade, reducing the amount of business they attract.
What do regulators really want? Easy: electronic trading of OTC derivatives. This key pillar of EMIR, Dodd Frank is a strong component of MiFID II. The concept of a central limit order book (CLOB) – normal practise in the futures markets – is the ultimate regulatory intent.
Overall, the MiFID II provisions seem designed to break up dealer banks’ client execution business, bringing key transactions in derivatives into more transparent markets. Dealer banks risk losing much of this, competing on new venues or chasing smaller numbers of more tailored trades. And it doesn’t end there.
The changing execution landscape adds considerable complexity to how banks assess their real cost of trading in order to establish a truly representative price.
For instance, you need to account for:
- the impact of multiple new execution venues where the same product can be executed;
- any material impact from the choice of CCP for the lifetime incremental cost of maintaining the trade;
- how netting sets and collateral optimisation models can help you deploy funding to best effect.
There are also other more subtle changes at play:
- selecting the correct trading and clearing venues and collateral allocation have been transformed from dry operational tasks with limited options to quasi front-office activities with significant bearing on both pricing and profitability;
- the speed of execution needs to increase greatly, requiring sophisticated analytic tools embedded as part of the OTC workflow;
- and, as the advent of SEFs in the US has already witnessed, the electronification of OTC markets will see reduced trade sizes coupled with increased volumes.
Those who fail to adapt or to automate their OTC business risk significant disadvantage.
Any remaining client execution business will be less profitable and more risky.
The move to new, more transparent trading venues means that previous OTC trading will become more commoditised, resulting in narrower spreads. This is a natural consequence of a move to multi dealer limit books, which display tradable prices and sizes from a number of market participants simultaneously, allowing clients to see all prices in the market, and obtain the best price.
For dealer banks who operate SI's, the requirement to provide ‘firm quotes’ will pose a challenge – applying whenever SIs transact with clients in instruments such as equity, bonds and derivative, which are traded and liquid at another venue.
When making firm quotes, the SI is obliged to make those quotes available to other clients, subject to a number of restrictions. On the surface this is laudable, as quotes are part of price formation, and should in principle be made more transparent.
But there are a number of scenarios, particularly for uncleared trades, where banks might argue they need to tailor quotes to individual clients. For example:
- where entering into the transaction reduces their overall existing risk profile with that client;
- where the client is highly creditworthy;
- where entering into the transaction would lower the bank’s overall capital, funding or bilateral margining requirements.
If banks are forced to offer a substantial volume of their quotes to all clients, it will become increasingly difficult – perhaps impossible – to offer any preferential quotes. While curbing preferential quotes for certain instruments may be ‘transparent’, it may also bring unintended consequences and increase risk, since:
- preferential pricing can incentivise trades that reduce risk between counterparties;
- preferential pricing is necessarily specific to each counterparty relationship and will no longer be possible in an environment where quotes must be offered to multiple clients; and
- there may also be a general withdrawal of liquidity, as banks become nervous of providing firm quotes to clients with whom they would rather not transact.
Meanwhile natural consequences include linking the bank’s internal credit risk systems to its trading activity to ensure trade execution certainty.
Overall, the effect of all this is to compound dealer banks’ pain. The removal of opacity exerts strong pressure on spreads for those transactions conducted on MTFs and OTFs, while offering tailored pricing as an SI will increase risks, as firm quotes must potentially be offered to all clients.
Dealer banks wishing to retain client execution and clearing must review their business.
In particular, banks should pay particular attention to client execution and proprietary trading practices and assess their real cost of trading accurately. That requires significant investment in technology, operational procedures and processes. Here’s where to start:
1. Get pre and post-trade transparency right first time. MiFID II’s transparency requirements greatly increase the need to process, assess and distribute information, both before and after the transaction. Many banks will find their IT infrastructure inadequate. With banks already reeling from fines over MiFID 1 transaction reporting, it’s essential to get MiFID II right first time.
2. See legal/operational reorganisation in the round. Dealer banks wishing to retain their execution business need to ensure their existing execution mechanisms meet new regulatory requirements. Given that an OTF and an SI cannot be housed in the same legal entity, this may well require legal reorganisation. Many banks are already undergoing protracted legal entity reorganisations in the wake of Basel III: MiFID II changes need to be incorporated into this overall scheme.
3. Make the right platform connections. As with SEF's in the US, the introduction of MiFID II is likely to result in significant market fragmentation, with a plethora of new trading venues vying for a share of the market. Connecting to the right new venues and ensuring efficient processing will be a significant challenge, as practices between venues are likely to vary – at least initially. 4. Deal with complex automation of pre-trade analytics. MiFID II adds complications to assessing the true cost of a trade. Enhancements to pre-trade analytics will be essential to ensure you get the best from your trading, clearing and collateralisation practices.
5. Forget the past. The old assumption that client execution can ‘subsidise’ clearing is dead: captive clients have decoupled. Failing to invest now is a serious mis-judgement, risking far more than operational inefficiency. How you act now will determine whether your business succeeds and remains profitable.
So where are the opportunities?
Wholesale change means a number of incumbents will lose out – and where there are losers there are winners. The opportunities for challenger dealer banks are significant.
Transparency is the new watchword. Those who embrace this mindset will gain ground.
MiFID II provides a milestone moment at which to leverage your investment in technology and address multiple regulatory headwinds to your advantage.
By far the biggest winners will be those who master pre-trade analytics and establish the true cost of trading. Making best use of the fragmented trading venue landscape, streamlining your clearing processes and using collateral efficiently will enable you to offer the keenest prices while still retaining – even increasing – profitability.
The same is true of core data. Banks are already striving to improve pre-trade analytics. Now, MiFID II’s transparency provisions massively increase data requirements. Finding smart ways to use this to your advantage will pay dividends.
Of course the prevailing view remains that dealer banks are overwhelmed by the pace and substance of regulatory change, not least:
- EMIR requirements to report transactions to Trade Repositories (TRs). The requirement to report transactions to Trade Repositories (TRs) has proven challenging for the dealer banks. This is a particular cause for concern, as in many cases failures to satisfy the previous MiFID 1 transaction reporting requirements have been identified, resulting in regulatory fines. This suggests there is further investment in technology required before all banks are fully compliant.
- BCBS 239 risk data aggregation. This is a technology prob- lem as well as a data issue. Large, geographically dispersed banking institutions rely on disparate systems, processes and methodologies, making it difficult for senior management to make key decisions based on robust information. Technology infrastructure, policies and procedures all need enhancement.
- Vickers (and Volcker in the US) structural reforms to the banking system. These necessitate substantial organisational restructuring and significant change in how execution and retail, corporate and wealth businesses interact.
- Bilateral Margining and the Fundamental Review of the Trading Book. More challenges lie ahead, as banks grapple with the regular exchange of margin (including replication of Initial Margin numbers and collateral optimisation), while upgrades to trading book risk measures require new risk models and methodologies.
Now, MiFID II overlays major additional requirements for greater transparency, speedier, more accurate reporting, enhanced execution, substantially improved connectivity and pre-trade analytics.
This is exactly the moment to take a different approach.
The common theme in this fraught landscape is the need for a truly strategic approach to technology and data. While trading is likely to become more complex as a plethora of new venues emerge, the open access requirements under MiFID also offer opportunities to simplify your post trade and clearing arrangements. This is a matter of efficiency and competitiveness, not compliance:
- enhanced pre-trade analytics will help you assess your trading costs more accurately;
- simplifying your relationships with post trade infrastructure will actually lower an important component of your trading costs;
- if true clearing competition breaks out and disrupts the existing vertical silo model, you may even be able to reduce your clearing costs.
MiFID II correctly identifies a number of potential competition issues associated with vertical silos, where the exchange also acts exclusively as the CCP for its own markets. Bundling and exploitation of market power are particular risks. Bundling can occur across the transaction chain, with trading and post-trade activities provided by the same group. As a result, users can’t easily determine the relative costs they are paying for each service.
The ability to execute transactions in similar instruments on different trading venues, then clear them via a single CCP of the dealer bank’s choice can, however, lead to margin efficiencies. The margin models used by different CCPs are not identical and clearing the same portfolio at different CCPs will produce different levels of IM and portfolio margining.
If CCPs and their users press ahead with true competition in the post trade space, the benefits could be significant:
- fewer CCP connections, as connections to a smaller number of horizontal CCPs allow full market access without the need to sign up to every vertical silo (and ideally give access to most EU markets);
- genuine competition and reduced clearing fees – analogous to the reduction in trading fees which resulted from the growth of MTFs as part of MiFID I;
- greater margin efficiencies, as correlated instruments become eligible for cross-margining in horizontal CCPs (for example, Bund futures traded on Eurex, Short Sterling traded on Liffe and IRS all cross-margined together).
Issues to watch
A degree of circumspection will pay dividends as the finer detail of MiFID II’s second level legislative process is clarified. In particular, keep an eye on:
Liquidity definition – a key concept with a number of central provisions applying only to those instruments which are deemed ‘liquid’ by ESMA. This includes the applicability of a trading mandate, the timeliness of transaction reporting and the requirement to provide firm quotes for SIs.
- The definition is already hotly debated and implications for various markets may be profound, particularly for instruments with long periods of illiquidity, followed by short periods of liquidity ‘on the run’.
- The final definition should be established in ESMA Regulatory Technical Standards. Expect this to be controversial.
Best execution for derivatives – ensuring best execution for less liquid products is a challenging topic to be settled in the next wave of MiFID materials.
- If anything, the fragmentation of trading venues makes best execution for derivatives a very tall order. A great deal of data will need to be provided by venues then properly assessed by the dealer bank, before best execution can be demonstrated to have occurred.
- The key concept is ‘fairness’ – another hotly debated term. Expect more details in the next draft of legislation.
Scope of the trading mandate – linked to liquidity, a fundamental provision will be which contracts are mandated for electronic trading.
- With European regulators still dragging their heels over clearing mandate timeframes, a key issue is the degree of overlap between clearing and trading mandates. In the US, the pool of trades subject to mandatory trading is a subset of those subject to mandatory clearing – it’s not yet clear whether the same will apply in the EU.
- The scope of the trading mandate is key to the success or failure of the new OTF venue type, with a significant impact on the sustainability of any SI business.
Detailed provisions for SIs – under MiFID I, only a small number of dealer banks were eventually recognised as SIs for equity. The number of SIs under MiFID II is expected to be significantly greater, covering those active in non-equity instruments.
- Central to the number of banks identified as SIs will be the criteria, based on the scale and frequency of activity. Equally important will be the organisational requirements, particularly regarding transparency and conduct of business.
- It remains to be seen whether acting as an SI will be an attractive and profitable activity once these new definitions are finalised.
MiFID IIbrings real opportunities: no bank should feel overwhelmed. Dealer banks in particular should address these priorities now:
1. Perform a full review of your OTC derivatives business.
If you haven’t already begun, you’re already behind. You need to validate your strategy and arrive at a new operating model. At a minimum, examine:
- what proportion of execution business you will be able to retain, and what is likely to migrate to other platforms. Unless you have concrete plans to operate an MTF or OTF, assume that a great deal of transactions subject to the trading requirement will migrate away.
- the investment required to meet MiFID II requirements for any business you wish to retain. This should include technology investment to meet transparency requirements for SIs, any changes in governance and conduct of business, operational and legal reorganisation.
- the profitability of your future execution and clearing business. Running this business will cost more while transparency pressurises margins further: this part of your business will be less profitable in future.
Armed with this analysis, decide which execution businesses offer potential and which should stop.
2. Don’t be blinded by the volume of change.
The last five years have seen ever larger sums spent to satisfy regulators’ manifold requirements. Yet it’s still not enough, judging from recent regulatory censure over MiFID 1 trade reporting failures.
To address the daunting volume of change, many banks separate streams for each new regulation. This is a mistake. Common themes on data quality and technology investment run throughout EMIR, BCBS 239 and now MiFID II: it is far more effective to search for synergies and build a single solution or framework to satisfy multiple requirements. What’s more, strong data architecture will not simply stand you in good stead for the current demands of regulation but will also future proof you against the next round of regulatory demands, while also improving the quality of management information available to run your business day to day.
3. Account accurately for the real cost of trading.
Such understanding is increasingly essential to the execution business. Leading banks are rapidly improving the sophistication of their pre-trade analysis. To remain competitive and ensure your prices represent your true costs while still maintaining your profitability, you must accurately understand the impact of the trading venue landscape, the cost of clearing and your funding costs.
You also need technology that can manage increasing volumes of information arising from new transparency requirements coupled with the right methodology to project your future costs – a particularly complex challenge for items such as Initial Margin over the life of a trade.
4. Invest for the future.
Trying to keep a lid on rising regulatory costs through tactical solutions brings risk – just consider the fines levied for trade reporting deficiencies.
With no let-up in sight, it’s time to assess your future technology needs. If you have already invested, leverage that wherever possible. If not, be realistic about the suitability of your current tactical arrangements and the risk of regulatory censure you’re running.
Above all remember that good technology and operational processes are not just about regulatory compliance. Wisely made and well implemented, these investments make for a more efficient organisation and improve the quality of information accessed by senior management. Getting MiFID II right might be the best decision you ever made.
This article was first published in edition 4 of Rocket, our magazine. Download available Rocket editions here, and save your up to date address in your profile to receive the latest hard copy editions as they become available.
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