There’s no doubting that the market has been anticipating the impact of the revised Markets of Financial Instruments Directive (MiFID II) since it was first announced way back in 2014. With 2016 finally seeing the release of the regulation’s wording – albeit with implementation not expected until 2018 – it’s time to examine how best to navigate the challenges of MiFID II, to maximize compliance while minimizing any impact on the operational landscape. In this article, we specifically discuss the impact of MiFID II’s regulatory framework on the over-the-counter (OTC) markets.
The background story – OTC
A high volume of financial and commodity assets such as securities lending and repurchase agreements, Government and corporate bonds and currencies (to name a few) are commonly traded over-the-counter (OTC) or off-exchange.
According to Wikipedia, OTC or off-exchange trading: ‘is done directly between two parties, without any supervision of an exchange. It is contrasted with exchange trading, which occurs via exchanges. A stock exchange has the benefit of facilitating liquidity, mitigates all credit risk concerning the default of one party in the transaction, provides transparency (such as standardizing products by matching a narrow range of quantity, quality, and identity, which is defined by the exchange and identical to all transactions of that product) and maintains the current market price.’
In addition, ‘products traded on an exchange must be well standardized.’ Meaning they ‘match a narrow range of quantity, quality, and identity, which is defined by the exchange and identical to all transactions of that product – this is necessary for there to be transparency in trading. The OTC market does not have this limitation. They may agree on an unusual quantity, for example.’
There are three principal routes for achieving liquidity for OTC assets, namely dealing direct with the buyer or seller via phone or email, using a broker or a physical auction. Unfortunately, there are many challenges associated with each of these routes, such as no/limited price discovery, limited market coverage, and transaction costs.
It is this scale and systematic risk potential which is seeing regulation, such as MiFID II, driving trading process changes in the OTC market.
MiFID II’s key capital market reforms
The effects of MiFID II on OTC marketplaces largely centre around the introduction of controls, with elements of the regulation specifying how certain asset classes should be traded. In order to effectively plan for the implementation of these measures, we first need to understand their regulatory impacts on the OTC landscape.
The main regulatory change is the establishment of a new type of trading venue for non-equities – Organised Trading Facilities (OTFs) – to capture those trades that would otherwise be executed OTC – a move designed with the aim of increasing pre and post-trade transparency. Systematic Internalisers (Sls) will also become increasingly important as the regime is broadened, with bond trading likely to take place on Sls as the market moves forward.
MiFID II also seeks to increase market transparency through the expanding of pre and post-trade transparency regime to equity-like instruments (e.g. depositary receipts, exchange traded funds and certificates) and to non-equity instruments (e.g. bonds, structured finance products, emission allowances and derivatives). The regulation will expand the scope of transaction reporting and establish a regime for the provision of an EU consolidated tape. Similarly, by introducing position reporting and placing quantitative limits on positions, the regulation seeks to improve oversight and transparency of commodity derivative markets and reduces systematic risk and speculative activity.
Other regulatory measures which will impact upon the landscape include the promotion of orderly markets through the introduction of specific provisions for algorithmic trading, and the promotion of competition in trading and clearing markets through the requirement that trading venues and central counterparties (CCPs) provide non-discriminatory and transparent access to one another.
It’s clear that MiFID II compliance will have much broader implications for the OTC market than those of the European Market Infrastructure Regulation (EMIR), which were largely a question of process and system changes.
The good news is that with its likely implementation date of 2018 – assuming no further delays – there’s plenty of time for the market to start getting its house in order and begin the planning process of how best to structure business activities around the regulation. Getting to grips with the forthcoming regulatory changes in advance of 2018’s planned implementation will mean that there are no surprises when the measures do come into force, and will allow for the early establishment of best practice operations.
Look for future commentary from Perfect Channel on this topic.