Non-Financial Risks, Regulation and Innovations
Best Execution - April 02, 2007

MiFID: the (in)famous European Directive?

In this study, EDHEC-Risk Institute, while recognising that the directive allows the conditions in which investment companies can operate on the regulated markets or over-the-counter to be harmonised, warns of the eventual adverse effects relating to the obligation of transparency for systematic "internalisers" and the obligation of "best execution". The authors find, in the case of the obligation imposed on systematic “internalisers” to maintain a public spread of prices, that it is prejudicial for this restriction to be removed for the least liquid securities. This provision will lead, in a certain number of cases, (small-caps on markets that are centrally organised at present), to a deterioration in the pre-trade transparency that is currently provided to investors.

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 known as Investment Services Directive II) was ratified by the European Parliament on April 21st 2004. The implementing Directive and Regulation were approved by the Parliament over the summer of 2006 and provide detailed implementation guidelines applicable to 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.

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, and recognises the need to include all participants in the execution cycle and all financial instruments under a consistent regulatory framework. It therefore goes far beyond equity markets only and will impact upon all market participants — buy-side, sell-side and trading venues (exchanges). The Directive introduces a passportable operating framework for execution services that can be provided by Regulated Exchanges (RE), Multilateral Trading Facilities (MTF)1, or Systematic Internalisers (SI)2.

The long-term implication of MiFID is undoubtedly the complete desegregation of the existing value chain related to execution services, owing to the end of monopolistic positions for exchanges, the creation of new opportunities for investment firms, the development of new business models and hopefully cost competition. This desegregation, however, is not free of risks for the quality of services provided to clients and the financial market structure itself. The main risks one ought to consider relate to the integrity of markets (safety of executed trades and efficiency of prices) and the protection of investors. These are two elements that the regulator should aim to protect in a fully liberalised marketplace.

MiFID provides some responses to both risks. Indeed, the Directive balances the opening of the execution landscape to full competition with a set of obligations that intend to increase transparency and investor protection in order to maintain European markets in a situation where the price discovery mechanism remains efficient and fair and where the markets’ overall integrity is guaranteed despite inevitable fragmentation. More precisely, this set of requirements exhibits three fundamental pillars:

  • Post-trade transparency obligation
  • Pre-trade transparency obligation
  • Best execution obligation
While EDHEC-Risk Institute has little concern about the first pillar (imposing stringent harmonized post-trade transparency rules on all execution venues and investment firms is rather a significant breakthrough, as we know that no public reporting currently exists for off-market trades), our main concern is rather about both pre-trade transparency rules and best execution obligation, which run the risk of not being as effective as they should be.

This expected ineffectiveness comes from either a lack of relevance in the way requirements are defined or a lack of accuracy in the way they have to be implemented. On the basis of Level 1 and Level 2 provisions, EDHEC-Risk Institute believes that the risk remains high that market fragmentation may result in less efficient markets, thereby adversely affecting the price constitution mechanism, and that investors may feel a sense of confidence in a protection that is actually not there.

Following intense negotiation with industry representatives, the Directive has restricted harmonised pre-trade transparency requirements to the most liquid equities only for investment firms operating systematic internalisation.

Hence, MiFID leaves room for the development of possibly opaque liquidity pools for non-liquid equities and other financial instruments, with little transparency on the order book, if any. More important is the fact that the regulator has just waived the pre-trade transparency obligation where it is probably the most necessary. In this paper, we observe that explicit transaction costs (brokerage fees) on less liquid stocks are nearly double those of liquid stocks. Similarly, we witness implicit costs related to transactions on illiquid stocks (according to the MiFID segmentation of the market) up to six times higher than those for liquid stocks. Because of increased fragmentation and less transparency, trading on illiquid stocks post-MiFID may well be even more costly than it is today. If fragmentation is a good thing for ensuring proper competition and force execution fees down, its impact on total transaction costs that depend upon the efficiency of the market structure is yet to be seen. The confusion that very often exists between transaction costs and fees seems to be there to stay, at the expense of the end investor.

The best execution obligation (article 21) is a key element for investor protection in a market that is open to competition. Initiated as an obligation of result in a principle-based regulatory approach, the best execution obligation has been actively fought by industry representatives and was slowly turned into a more modest obligation of means that remains complex and ambiguous, if not overly prescriptive. With such an unbalanced provision, there is little chance of the industry embracing the concept and actually delivering upon the Directive’s promises.

Worse still, with no other definition than an obligation of means (that of clarifying an execution policy, being transparent on that policy and ensuring the policy allows achievement of the best possible result on a consistent basis), MiFID is in fact likely to significantly increase adverse selection and moral hazard. By aiming to strongly protect the end investor in a largely liberalised environment, the European regulator may well have put itself in a situation where some participants will risk “singeing their wingfeathers” despite being highly confident that the Directive requirements are working in their favour.

Obviously, this opinion should not be read as a death sentence for MiFID, which remains a very welcome initiative, but rather as a strong call to the industry to reinvent itself and develop a proper evaluation framework that will shed some light on the actual quality of the service offered to professional and retail clients.

This paper is a call for the industry to seriously embrace a reflexion on how the quality of service is and should be measured in order to adequately protect the end investor in a context where a deliberate fragmentation of supply might not be counter balanced by adequate protection measures.


1 Similar to Regulated Exchanges in that they allow clients to enter into negotiations without taking part in a transaction as a counterparty. They include all forms of multilateral negotiations such as order books, block trades, periodic auctions and any other form of mechanism resulting in negotiations to be agreed between two counterparties.

2 This new regime allows investment firms on an organised, frequent and systematic basis to deal on their own account by executing client orders outside an RE or MTF.

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(1) http://www.edhec-risk.com/research_news/books/RISKBook.2006-11-07.5945