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Market Regulation - November 08, 2006

Interview with Catherine D'Hondt and Jean-René Giraud

On the occasion of the publication of the first book devoted to the consequences of MiFID for the sell side and the buy side in the asset management industry, MiFID: Convergence Towards a Unified European Capital Markets Industry, co-written by EDHEC's Catherine D'Hondt and Jean-René Giraud, we discuss the issues surrounding MiFID with the authors.

Catherine D’Hondt is associate professor at EDHEC Business School in Lille with a primary research area in market microstructure and a special focus on traders' behaviour and order submission strategies. Jean-René Giraud is Director of Development of the EDHEC Risk and Asset Management Research Centre, involved in several research programmes targeted at operational issues related to the hedge fund and the asset management industry.

What is MiFID?

Jean-René Giraud and Catherine D'Hondt: MiFID is the second step in the harmonization of the European capital markets industry and aims to adapt the first Investment Services Directive (ISD 1, issued in 1993) to the realities of the current market structure. Part of the European Financial Services Plan (FSAP), the “MiFID” (Directive 2004/39/EC, formerly know as Investment Services Directive II) was ratified by the European Union Parliament on April 21st 2004. Implementing Directive and Regulation were approved by the Parliament over the summer 2006 and provide detailed implementation guidelines consistent across all member states. Local regulators are currently working on the third level of this new regulation, with specific and local implementation measures that will come into force no later than November 2007.

MiFID recognizes the existence of new forms of execution and the need to include all participants in the execution cycle and all financial instruments under a consistent regulatory framework. It goes therefore far beyond equity markets only and will impact all market participants, buy-side, sell-side and liquidity venues (exchanges)

In a nutshell, MiFID sweeps away the very concept of central exchange and obligation of order concentration as it currently exists in several European countries. It introduces a passportable operating framework for execution services that can be provided by regulated exchanges, or multilateral trading facilities, or internalised inside the financial institution itself. The opening of the execution landscape to full competition is balanced by a series of obligations that intend to increase transparency and client protection in order to maintain European markets in a situation where the price discovery mechanism remains effective, fair and where the markets’ integrity is guaranteed despite an inevitable fragmentation.

What is the main objective of this book?

Jean-René Giraud and Catherine D'Hondt: The main objective of this book is to provide a single source of information on the newly issued regulation. This book covers the practicalities of MiFID and a review of the potential impact on the industry. The reader will be given a practical understanding of the directive’s impact on investment firms and develop a vision of the broader changes the directive will generate amongst industry players.

Bringing together the viewpoints of both academics and practitioners, possible ways forward are suggested allowing to better understand how the industry will evolve over time.

What are the reasons that convinced you to write this first book on this coming piece of regulation?

Jean-René Giraud and Catherine D'Hondt: Writing on European regulation is not straightforward. This book comes as a response to a significant number of articles and opinion pieces that have recently been published and, in our eyes, fail to correctly explain what MiFID really is and how it will impact market participants. Very often used as a justification for technology or consultancy spending, it is important that asset managers and intermediaries properly understand the basis of the regulation, the main unresolved issues and obviously get an idea on how it will change their future business.

With many organisations misunderstanding the implications of MiFID on the capital markets industry as a whole and more specifically on their own firm, developing a better understanding of this significant piece of regulation has become vitally important.

MiFID strongly emphasises an increased level of protection for investors. Do you believe the Directive will deliver on that promise?

Jean-René Giraud and Catherine D'Hondt: If the intentions of the Directive are clearly to protect the investor, the practical implementation details leave however significant question marks on the results one can expect from the new rules.

First of all, in order to protect the market structure and the price discovery mechanism, the regulator request a certain number of pre-trade transparency obligations to be fulfilled. Following intense lobbying from various participants, the Directive restricted this pre-trade transparency to the most liquid securities only (initial analysis seem to show that only 600-700 securities listed equities on the largest European exchanges are covered). Post MiFID, less liquid stocks and other financial instruments (bonds, ETFs, listed futures and options, spread bets, OTC transactions) will be traded on or off exchange without incurring any form of pre-trade transparency leaving room for the development of possibly opaque liquidity pools with no clear transparency on the order book if any.

Secondly, a very important element of investor’s protection lies in the so-called ‘Best Execution’ provision, or Article 21 of the Directive. Within the 2004 Directive, the Best Execution obligation has been defined as an obligation of means whereby investment firms are required to have taken all reasonable steps to obtain the best possible result for the client.

Even though the “Best Execution”’ obligation is an absolute requirement to protect investors and market participants, it is currently causing significant concern among industry participants for two main reasons:

  1. a total absence of consensus on what best execution means, in particular because of the differences in clients’ requirements, but also because of the absence of a conceptual framework for measuring the quality of execution;
  2. the difficulty of demonstrating that one has satisfied an obligation of means. In most circumstances, clients and intermediaries may end up discussing the specifics of a transaction that could have justified different treatment.

The most troubling issue with the provision is the significant inconsistency in how the first paragraph of the chapter is structured. This paragraph starts with an obligation of means summarized as an obligation to “take all reasonable steps to obtain the best possible result”, which is clearly inconsistent with an attempt to create an obligation of result as suggested by the emergence of a definition of what the best result should be “… taking into account price, costs, speed, likelihood of execution and settlement, size, nature or any other consideration relevant to the execution of the order”.

At this stage, the regulator has put itself in a somewhat schizophrenic situation wherein any attempt to state what a “best net result” for the client is, would indubitably cause about half of the industry to rise up in opposition on the grounds that Article 21 is, and should be, an obligation of means; and, at the same time, the other half of the industry is complaining about a too-prescriptive article that is not consistent with an obligation of means and/or a principle-based regulation.

With such an unbalanced provision, there is absolutely no chance that either the industry or the investor will develop a sense of confidence that the regulation is fair and protective of each other’s rights.

Is the EDHEC Risk and Asset Management Research Centre working on identifying solutions to these issues?

Jean-René Giraud and Catherine D'Hondt: Because it is our aim to attempt providing elements of solution, our team has developed an innovative framework for analyzing transaction costs. And because Peer group or relative analysis are frequently demolished by market participants that consistently identify good reasons not to accept a benchmark or a peer group as relevant for assessing the quality of their trade (under the justification of more or less relevant arguments), we have opted for an absolute measure of the price obtained.

The EBEX framework, which is described in its full extent in the book, provides a unique approach to measuring the quality of a transaction with regards to the price obtained, and benchmark the final result with the full universe of transactions reported in the industry. Such an approach allows the investor to easily determine whether the quality of his intermediary, trader or even algorithm, sits in the first quartile or rather in the bottom of the classroom. EBEX is being actively discussed between professionals and academics and we are certain that positive evolutions will be proposed in the very near future to allow it to cope with specific situations the first version did not cater for. We will obviously continue taking part to this permanent dialogue and we look forward for constructive exchanges to happen in the coming months.