Mifid II meddling comes at a cost

The European Union’s Markets in ­Financial Instruments Directive II, at least six years in the making, came into effect this week.

At the risk of prompting a bout of financial regulation fatigue, the European Union’s Markets in ­Financial Instruments Directive II, at least six years in the making, came into effect this week.

Mifid II, as the new rules are known, couldn’t possibly be as disastrous as Basel II, the parallel ­Europe-dominated system of bank regulation that fuelled the global financial crisis. But nevertheless, I see it as Meddling in ­Financial Instruments Dubiously II.

That’s because the huge complexity and cost of the reforms, which have been thrashed out over more than seven years, foist massive compliance costs on market participants and the bureau­cracy, which will inevitably be passed on to the ultimate users.

Moreover, Mifid II will almost certainly have unintended consequences whose severity could even offset well-meaning goals of making trading in bonds, shares, commodities and related derivatives more transparent and competitive. The changes, which run to more than 1.3 million paragraphs, might not be worth the candle.

Certainly, they are a boon for the financial compliance sector, though.

Mifid II has implications for all banks and asset managers, whether they are in Europe or not. Australian banks, for instance, will have to comply to the extent they trade with institutions based there, and banks with heavy presence in Europe may well just incorporate chunks of the new rules in their own organisations in anticipation of other jurisdictions following suit.

The new regulations require far more extensive keeping of records for trades. “The rules also introduce greater transparency around bond trading, forcing brokers to publish prices for the most actively traded securities before trades are completed,” The Wall Street Journal reported this week.

They also encourage trading to migrate from relatively shady over-the-counter markets to ­exchanges where prices and volumes are publicly available. So-call dark pools, where financial instruments can be traded off-market, might become more puddle-like given Mifid entails “double volume caps” that outlaw “dark trading”, when a trade ­exceeds 4 per cent of the activity in a particular pool.

Mifid also forces banks and brokers (they are typically the same thing, thanks to decades of mergers in the financial service ­industry) to put an explicit price on the market research they produce, which is typically given for free to clients (including journalists, whose lives, it must be said, are made much easier by it).

The idea is to stop investors from having to pay for huge quantities of expensive research they probably don’t even know they are paying for. Fund managers might choose to do their own research or simply start paying for it, with or without passing on the cost to their own clients.

Estimates suggest spending on research and trading could fall by billions of dollars globally as a result. That could be a lot of well-paid jobs out the door.

My guess, though, is the industry won’t be much affected. Take this high-profile issue of unbundling of research. What stops a broker setting the price of the research lower than its actual cost, let alone including any mark-up?

Regulators don’t have the knowledge or capacity to second-guess the pricing of a product that has no price anyway. Cross-subsidies within financial institutions, indeed most institutions, are rife.

Similarly, what even is research? Do phone calls and emails from sell to buy side count? Who will draw and enforce the line? The outcome of Mifid II may simply be to create more paperwork.

Banks will also need to put an explicit price on their underwriting services. The problem here is these direct fees, typically as a percentage of the sums of shares or debt underwritten, have been ­arbitrary.

The financial benefit for a bank of underwriting stems largely from its ability to give favoured and ­lucrative clients access to the offer.

Trading volumes in bonds dropped on Wednesday, the first day of Mifid. Bond trading has traditionally been the murkiest of the major classes of traded securities.

Whether volumes decline shouldn’t be the test of Mifid’s success or failure. Given the vast array of anti-competitive regulations in finance and the implicit backing by governments of the banks that do the most trading, no one knows what the normal free market level of trading actually is.

Perhaps the biggest problem in securities markets is the decline of trust in the major institutions that participate in them. Mifid doesn’t fix this. Their sheer size, access to information, incentive to cross-sell products, and ability to subtly profit from the flow of information has made them incredibly effective money-making machines.

It would have been simpler, for instance, to outlaw deposit-taking institutions from having anything to do with trading or securities markets, and then the whole need for Mifid and all the costly bureaucrats and compliance staff that go with it would be gone. Who cares about trading and its structure if it has no ability to bring down a bank or affect the macroeconomy?

It’s important to dwell on new financial regulation because ­finance has become by far the biggest sector in most advanced countries, and so it has particular consequence.