Of MiFID and Market Data

The water is rising, but its depth is still obscured by the fog of bureaucracy. Already, the purling and gurgling can be faintly heard through the din of committee meetings, press conferences and panel discussions. The market data flood is coming, but for now, its impact remains confined to the pages of analyst reports.

The beast behind the flood, of course, is the Markets in Financial Instruments Directive, or MiFID. Financial firms balked at MiFID, and returned to the regulators full of questions and requests for clarifications. Analysts eagerly got to work, peddling reports about the predicted effects of complying with the regulation that promises sweeping changes to the European markets.

In its current form, the regulation includes provisions for transparency of pre- and post-trade processing, outlines best execution requirements for firms, and brings an end to concentration rules that force equities orders to be sent to a national primary exchange.

The directive is following a four-phase legislative scheme labeled the Lamfalussy process. In February, the European Commission submitted the formal draft of Level Two of the legislation. The Level Two text adds technical implementing measures to the principles outlined in Level One. The European Securities Commission now has until June to comment on the measures, after which the European Parliament will have a month to review it. The draft measures will then be formally adopted by the EC this summer.

While the wheels of bureaucracy slowly grind the Directive into a form ready for implementation, firms are scrambling to understand how to deal with the specifics of the Directive. Despite the recent release of the Level Two text, the general implications of MiFID remain largely unchanged. It abolishes concentration rules, under which some member states require investment firms to route orders only to central stock exchanges. This will expose exchanges to competition from multilateral trading facilities (MTFs)—that is, non-exchange trading platforms and systematic internalizers (SIs), which are investment firms that systematically execute client orders internally on their own accounts. For MTFs and SIs, MiFID designates similar pre- and post-trade transparency requirements.

While MiFID tackles separate elements of the trading cycle, one segment of the market will be fundamentally altered at every stage of the cycle: the processing of data.

Why Data?

A survey of the implications of MiFID makes clear that the structure of the market data industry will be transformed dramatically. The end of concentration rules could allow for many new, competing trading venues, resulting in more sources of data for firms and vendors to aggregate. And the requirement for SIs to publish quotes will probably result in an increase in pre-trade quotes published to the market. Firms must also record and retain five years' worth of data to prove that they are keeping to their published best-execution policies.

The potential impact of such changes on volumes of real-time market data and its value is significant, as are the implications for the development and use of reference data—and tied in with data markets is the future of the incumbent stock exchanges.

Industry players agree that one of the most significant drivers for reform under MiFID is the fragmentation of data sources. "If you're an investment firm in an EU member state, you can be confident going to the central exchange as a primary source of liquidity," says Andrew Allwright, manager of regulatory commercial strategy at Reuters. This means that the central exchange will be a primary source of data. But after MiFID and the end of concentration rules, firms will be able to choose where to report trades and how to publish post-trade data. "There will be competition among exchanges for publishing post-trade data," he says.

Nor is it only the operators of trading venues that will have to adapt to competition. Data vendors will need to aggregate data from multiple sources, even for single stocks. As a result, Reuters' interest in MiFID is not academic.

"As a vendor of data, we will have to source data from all potential aggregators of data," says Allwright. "The role of the data vendor will become more complicated as sources of data multiply."

Given the requirement under MiFID for execution venues to make available pre- and post-trade information to the public on a "reasonable commercial basis," according to EU guidelines, competition between data distributors looks to become all the more bitter.

One data user is clear on MiFID's impact on data volumes. "Market data tick volumes will rise as all European markets potentially admit all European securities for trading on a pan-European basis," says Kevin Bourne, global head of execution trading at HSBC. He says that the post-trade intra-market reporting requirements to the primary market will also have a significant impact on data traffic.

However, while sources and volumes of data will multiply, Glenn Bedwin, director of institutional research at Thomson Financial, says that data vendors already face the challenge of gathering data from around the world and consolidating it into a feed. "MiFID will bring extra challenges, but from an aggregation perspective, they are manageable and present opportunities for vendors," he says.

But the post-MiFID market data scene is not as simple as multiple trading venues, all publishing pre- and post-trade data. Allwright says that if a firm is counted as an SI under the MiFID regulation, it can take one of two approaches—its status as an SI can be either a commercial opportunity or a regulatory obligation. "My gut feeling is that a large number of potential SIs look at it as more of the latter," says Allwright. In his view, the possibility is there for a proliferation of low-quality pre-trade quote data, as SIs publish quotes merely to comply with MiFID.

The number of SIs post-MiFID is, therefore, a crucial factor in determining the impact of MiFID on the EU financial services industry. "We still don't know how many systematic internalizers there will be," says Richard Gissing, CTO of Gissing Software. Estimates for the final number of SIs after MiFID vary widely. Gissing says the consensus is between 200 to 250 SIs across the EU after MiFID, but Reuters' Allwright offers a far more conservative estimate of 10 to 20 SIs. The uncertainty arises from the variety of firms and approaches across the EU, and the fact that internalization of trades has been illegal in most countries until MiFID—the notable exception being in the UK. The only certainty is that some firms will become SIs, and the volume of data will increase—but by how much is unclear.

Roberto Rivero, a consultant with UK firm Intelligent Growth, says the biggest impact of the Directive will be the fragmentation of data sources, and the biggest losers under MiFID will be the established exchanges. He says data costs will not come down, but the pricing power of exchanges will fall along with their market share as trading venues proliferate. "People at the exchanges are writing off their reporting fees," says Rivero, pointing out that firms are no longer required to report trades to a specific exchange, opening up reporting fees to competitive pressures.

Many exchanges charge firms for fulfilling their regulatory requirements by reporting trades via exchanges. Under MiFID, firms will have the option to report trades by a variety of means, including a Web site set up especially for the purpose. As a result, Rivero says exchanges will no longer charge for firms to report trades via their infrastructure.

Nick Dutton, manager of regulatory strategy for the London Stock Exchange, says he doesn't believe London will be significantly affected. While he says there will be competitive pressures regarding reporting fees, extensive fragmentation of liquidity is unlikely. "In places like Italy, France and Spain, the end of concentration rules will mean that firms aren't forced to trade on specific platforms," says Dutton. "So under MiFID, we will probably see business move away from the order book." In London, however, Dutton says the LSE's central order book will maintain its position.

"In the London market, the LSE sits in the middle, with larger investment banks such as Credit Suisse and Lehman Brothers as liquidity pools in their own right," says Dutton. "The LSE's order book allows interplay between the other pools of liquidity—and MiFID is trying to encourage this model in other jurisdictions. We're pretty much there already."

HSBC's Bourne says the increased competition brought in by the legislation will bring new pressures to the markets. "Without doubt the legislation will permit open and direct competition by all markets on an equal basis," he says. "The more established automated order book platforms with high volumes will, unless they merge, face a very demanding operating environment with eroding margins," he adds.

Terms of Reference

Aside from the well-worn issues around market data, reference data will be an issue post-MiFID. For starters, the definition of reference data is unclear. Tony Kirby, director of financial services in the UK at consultancy firm Accenture, and co-chair of the reference data element of the London-based MiFID Joint Working Group, says reference data comprises instrument identifiers, including end-of-day pricing data; client/counterparty business entity data; corporate actions data; and ancillary data, such as tax and calendar data, that is needed to complete a trade.

Kirby says he hopes firms are aware of the need for focused reference data governance and policy in light of MiFID. Firms might use a solution provided by a data vendor, application provider, exchange, or other third party. "However, firms need quality reference data to prove best execution compliance," Kirby says.

As the MiFID deadline draws closer, firms are working on levees and dams to harness the market data flood. By 2010, expect to see a transformed EU market where a reformed market data industry will merely be the backbone for a more transparent and competitive European marketplace.