The European Union's Markets in Financial Instruments Directive (Mifid) is a step closer following the publication of draft implementation measures on February 6. The 'Level 2' measures add much-needed clarity to what financial institutions must do to comply with the rules, which seek to create a single market for financial services in Europe. And risk managers will have their work cut out if they are to be ready for the November 2007 implementation date.
Take the requirement for best execution, for example. Firms must decide what factors affecting best execution should be given priority for each customer (for instance, price, cost or speed), analyse all the available execution venues (such as exchanges and market-makers), and try to set themselves up so they can execute trades at these venues.
When looking at the cost of a transaction, the firm must consider indirect costs, such as market impact and implementation shortfall, and look beyond the bid and offer price - commissions, taxes, exchange fees and clearing and settlement costs have got to be taken into account. And it has to decide which venue offers the best deal for clients on a trade-by-trade basis, periodically reviewing which execution factors should be prioritised for each customer.
And it's not just equities. This policy also holds for dealer-dominated markets such as fixed income and foreign exchange, as well as customised over-the-counter derivatives transactions. Thankfully, Mifid acknowledges that the price of a derivatives contract is often based on subjective variables such as counterparty credit risk, so it is not possible to apply best execution obligations to derivatives in the same way as, say, shares. However, investment firms are expected to test and compare the market values of other variables involved in pricing a derivative.
Elsewhere, firms will be required to assess the suitability and appropriateness of a transaction for a particular client. The level of detail required will depend on whether the customer is a retail or professional investor, but all derivatives transactions will require some level of appropriateness or suitability assessment. That's even the case for plain vanilla derivatives products such as warrants - a requirement that could significantly increase compliance costs for warrants issuers in Europe.
Many people agree that the general principals of Mifid - to protect investors and ensure they receive the best deal - are praiseworthy. But most derivatives houses already have appropriateness tests in place, particularly for structured products aimed at retail investors. Is formal legislation really the answer, or should the EU have relied on self-regulation?
The formal implementation measures won't be finalised until this summer, at which point the directive has to be interpreted by domestic supervisors and enacted into national law by January 2007. Firms then have less than a year to implement all facets of the rules - not long considering the development in IT that will be needed to comply with the best execution obligations. Mifid was recently delayed from its scheduled implementation date of April 2007. Is it time to delay once again?