Mifid’s great race to the bottom

At the start of the year, market participants were complaining about the lack of clarity on how to interpret many key elements of the new rules within the second Markets in Financial Instruments Directive (Mifid II). With less than three months to go, the mood seems to have changed: if the regulators can’t agree how the rules will be applied, why not adopt as soft an interpretation as possible? After all, regulators won’t be handing out prizes for banks who take a tougher line on compliance than their competitors.

There are growing signs each participant is looking for the approach that benefits them the most – irrespective of whether legislators intended a harsher version of the rule.

In the UK, the Financial Conduct Authority has made clear it intends to act proportionately against firms that transgress at the outset of Mifid II, leaving the threat of early fines unlikely. But proportionality seems dependent on the amount of work firms have put into complying with the rules; a bank could spend thousands of man hours complying with Mifid II and be able to present regulators with records of how it had done so, justifying the decisions taken – while still only implementing the softest version of the rules.

One large bank bidding to become a systematic internaliser (SI) recently told Risk.net it was prepared to take on a certain amount of “regulatory risk” to get its SI entity ready in time for January, cutting corners so it could provide trade reporting services to clients from the off. A further point of obscurity is the granularity at which an SI should opt into the regime – from an entire asset class down to individual instruments. Here again, dealers indicate they will choose the approach that fits their strategy rather than trying to work out exactly what regulators originally intended.

Perhaps the most serious concern is that Mifid II is meant to help European Union markets operate on a more integrated basis, but instead banks are looking for opportunities to arbitrage between different national interpretations of the rules. For instance, Nordic regulators plan to impose only short deferral periods before banks must report trades in instruments deemed illiquid. Italian market participants suspect their regulator may adopt the same approach. But the UK will allow the maximum permissible four-week deferral on post-trade transparency for the same trades.

It’s no surprise Nordic banks are looking for ways to book their trades under the UK regime. They have found two options. The first is to use a contentious trading protocol offered by multilateral trading facilities, which allows bilateral negotiation of trades that then conclude on-venue. The MTFs differ among themselves about how to ensure this protocol complies with the Mifid II obligation to trade on-venue. And electronic principal-trading firms claim the whole protocol is undermining the trading obligation. All of which should set alarm bells ringing in regulators’ offices.

The second path for Nordic investment banks to the UK’s deferral regime might be to locate trading books in London. There is currently ambiguity as to which jurisdiction’s deferral period applies if the different processes around a transaction occur across various member states. A common interpretation among sources is that the post-trade transparency rules apply wherever the seller books the trade.

If that is the case, one Nordic investment bank says they could easily relocate one of their books to London. The Scandinavian desks could continue to act as sales agent, but they would be able to use the UK’s deferral period. It remains to be seen if regulators will ultimately give this approach the nod, or if they will try to impose transparency requirements in the jurisdiction where the trader sits.

Then there is the aspect of Mifid II that has generated perhaps the most angst among banks and their clients: the obligation to unbundle fees for investment research from other trading commission fees. Risk.net has been given a foreign exchange research note containing a page-long disclaimer explaining how it is not research (as defined in Mifid II), but rather a sales aid provided by the bank’s trading desk analyst.

Whether this suffices to get around the research rules is questionable. As one lawyer puts it: “If you call a cat a dog, it doesn’t mean it is now a dog.”

Banks are also homing in on how to interpret the word “substantive”, used in Mifid II as a defining characteristic of research. The note seen by Risk.net is light on words and in-depth explanation, so maybe it is not “substantive”. But it does identify cheap currency pairs based on the bank’s own calculations, which is certainly actionable information for a client.

At the moment, regulators are battling to get over the Mifid II finishing line on January 3, 2018. But as soon as that marathon is finished, it looks as if they will have further to run to bring market practices into line not only with each other, but also with the actual intention of the rules.