European financial services firms are almost seven weeks into the brave new world of Mifid II. FOW spoke to a number of regulatory experts on the initial impact of the rules, the remaining issues and what we can expect from the regulation for the remainder of the year. 

Soft launch

“Implementation went much better than some in the marketplace had feared.” Christian Voigt, senior regulatory advisor at Fidessa told FOW.

Voigt’s comment reflected the general tenor of the first month of Mifid II. Some called it a ‘soft launch’, while others simply noted that implementation panned out largely as was expected, in spite of the last-minute panic about certain requirements or the readiness of smaller financial firms that dominated financial services coverage in November and December last year.

The relatively quiet first month of compliance with the regulatory behemoth stands in contrast to all the “big bang” rhetoric from financial services firms last year.

“By and large the industry was ready, but some regulators were not. For example, some registers were poorly populated on January 3. At least one regulator’s transaction reporting infrastructure failed," Conor Foley, head of government and regulatory affairs at Norton Rose Fullbright, told FOW.

Foley also pointed to the eleven European Union member states that had not yet fully implemented Mifid II into local law. The lack of clarify in countries like Luxembourg, Poland, Portugal and Spain leaves gaps for compliance and enforcement.

“This is a big problem if you’re an investment firm or market operator based in one of these member states. Of course, this circumstance is not without precedent and tardy member states ought to remember that the Commission was neither slow nor gentle in dealing with laggards in 2007 and 2008 on Mifid I transposition,” Foley said.

Also on the local level, the initial days of Mifid II saw regulatory data processing engines go down for limited periods of time, exposing issues with reporting.

Hiccups

“We’re a month in now, and implementation panned out largely as we expected, but it has highlighted some issues with the reporting regime. The issues and questions that were there before January 3 have remained,” said Adrian Gill, regulatory compliance specialist at NEX Abide Financial.

The market has seen a number of transaction reporting rejections on instruments, for example, because Esma’s financial instrument reference data base system, which details ISIN identifiers for all financial instruments, cannot be entirely relied upon. The regulator has acknowledge this issue.

These types of hiccups at the central source for data have caused regulatory reporting challenges further down the compliance waterfall.

The position limits regime for commodity derivatives was also quite controversial upon introduction and have caused some worries among market participants that deal in these products.

“The initial reaction to position limits for commodity derivatives was ‘no one will hit these’ but nuances in application and the aggregation requirement has meant that some market participants tightly constrained. Note the FCA’s response to reset some bespoke position limits to address,” Foley said.

The FCA is reportedly also evaluating reporting compliance and looking at whether all instrument coverage and data quality and quantity are at appropriate levels. Gill said his firm expects additional guidance from the UK’s regulator in the first quarter of 2018.

Impact

An area where fears were allayed by the first month of Mifid II was liquidity. Prior to the January 3 deadline, alarm bells were sounded that the regulation had the potential to fragment the European trading market similarly to the way that the US market was broken-up by the Dodd-Frank Act and that liquidity would suffer in the first few months after the directive entered into force. But in spite of these fears, London-based prop traders noted that liquidity in the initial days of Mifid II compliance was on par with the end of last year.

“From a volumes perspective, we’ve not seen a drop in liquidity, rather the opposite has happened in the first month of 2018,” said Gill, referring to increased trading volumes during January 2018.

The impact, however, was felt elsewhere in shifting trading patterns.

“So far, we only have one month of data and the true impact of the regulation might only become apparent after a year or so, as was the case with Mifid I. Nevertheless, we’re already seeing some interesting patterns such as the massive decrease in OTC volume and a very large shift to SI volumes,” Voigt said.

He also noted an increase in block trading above the large-in-scale sizes, a trend which had already begun in 2017 in anticipation of the Mifid II transparency rules and the double volume cap, the latter of which was ultimately delayed. Voigt was confident this trend would continue.

FOW reported in January that experts saw buy-side firms conducting a higher number of block trades, as the unbundling rules in the regulatory package enable them to seek lower trading costs.

“There is also a marked growth in the use of periodic auctions driven by the introduction of the trading obligation for shares. The periodic auction is a new mechanism that meets the needs of the buy side and sell side,” Voigt concluded.

What we have to look forward to

Although the January 3 deadline was on the top of everyone’s minds when it came to Mifid II compliance, the date was only the beginning of a stop-and-start process of regulatory change. New elements of the regime will come into force in March, when the double volume cap will impose limits for products traded in dark pools and then again in June, when several rules for commodity traders will be implemented, and finally in September, when the systematic internaliser regime will come into full force. 

“The parts of the regulation that could have caused chaos are further out, for example the double volume cap or have been applied with very limited scope such as the derivatives trading obligation,” Foley pointed out.

The effects of the regulation, in other words, will also only come into focus when Mifid II is completely implemented, which may take a very long time, given the open access rules will only come into force for most exchanges and clearing houses a full 30 months from now.

“In the next twelve months, I expect to see a couple of long terms effects emerge. We’ve already seen some short term changes in research as a result of the unbundling rules, but it remains to be seen whether we will see a growth in research-only firms, or we’ll see the banks providing both research and execution services,” Voigt said.

Other longer-term effects of the regulation can be tied into the reporting requirements. In the beginning of February, for example, the market saw the impact of high frequency and algorithmic trading techniques on the market. Thanks to Mifid II, the regulators will be able to perform quite the granular analysis on these phenomena.