Updated: May 7, 2010 (Initial publication: May 5, 2010)
Bibliographic Reports : Grey Litterature
After two years of implementation of France, the 2004 Directive on markets in financial instruments is to be reviewed at the European level in 2010. The French report, elaborated by Pierre Fleuriot, examines whether or not the directive’s main objectives –the deregulation of markets and the lowering of trading costs- were achieved in an efficient way.
Directive 2004/39/EC on markets in financial instruments (MiFID - also referred as the financial instruments Directive), which has been implemented in France on Nov. 1st 2007, must undergo a European reviewing process in 2010. Each Member State therefore submitted at the beginning of the year a reviewing proposal, which French Minister of the Economy Christine Lagarde delegated to Pierre Fleuriot. The latter, CEO of the French Crédit Suisse, submitted his report on February 17th. After 2 years of application in France, Mr. Fleuriot draws up several conclusions on the accomplishments and/or failures of the directive and attempts to offer solutions to the identified flaws.
At the offset, one must recall that the Financial Instrument Directive’s primary objective was to repeal the Council Directive 93/22/EEC on the investment service, in order to eliminate the order concentration rule, i.e. to put an end at the de facto monopoly of regulated markets (such as Euronext). Indeed, “the authorisation to operate a regulated market should extend to all activities which are directly related to the display, processing, execution, confirmation and reporting of orders from the point at which such orders are received by the regulated market to the point at which they are transmitted for subsequent finalisation, and to activities related to the admission of financial instruments to trading (§49 of the MiFID). The opening to competition of all trading facilities therefore led to the redefinition of the European financial market’s landscape. What good did it do to European investors and issuers?
Since the MiFID was implemented, orders are no longer concentrated on one single regulated market but can also be negotiated on other Multilateral Trading Facilities (MTF – such as “dark pools”), the functioning of which is quite similar to those of regulated markets ; stocks may also be exchanged through systemic internalisers or even through “cross networking” (see below). Indeed, §49 of the Directive provides that the Directive also refers to “transactions concluded through the medium of designated market makers appointed by the regulated market which are undertaken under its systems and in accordance with the rules that govern those systems. Not all transactions concluded by members or participants of the regulated market or MTF are to be considered as concluded within the systems of a regulated market or MTF. Transactions which members or participants conclude on a bilateral basis and which do not comply with all the obligations established for a regulated market or an MTF under this Directive should be considered as transactions concluded outside a regulated market or an MTF for the purposes of the definition of systematic internaliser”.
It appears as the directive’s objective to open financial markets to competition is a success in regards to the number of new trading facilities existing today. Indeed, they are today 24 unregulated markets where only 14 existed before the Directive’s implementation. Moreover, unregulated markets are already responsible for 30% of the trading of the main stock exchange securities.
Through the deregulation of financial markets, the directive was aiming at lowering the cost of trading services and at increasing market liquidity. Furthermore, in order to protect investors, the directive attempts to toughen up transparency rules and to impose on investment services firms a “best execution” standard in the execution of their clients’ orders. The “best execution” obligation is bound to ensure that investment firms execute the client’s orders on terms that are most favorable to him. “This obligation should apply to the firm which owes contractual or agency obligations to the client” (§33).
Unfortunately, and perhaps because of the financial crisis’ exceptional circumstances during which the directive was first implemented, the Fleuriot Report seems quite skeptical regarding the text’s achievements. Indeed, the lowering of trading costs does not seem to have benefited the investor himself but rather to intermediaries, and the pre and post-trading transparency information obligations appear to have uneven consequences.
The two main achievements of market deregulation are still awaited.
Regarding the expected lowering of transaction costs, it seems that the costs and associated charges for financial transactions have, overall, decreased. Indeed, a study requested by Bruxelles shows that the decrease of transaction cost has reach 33%, and that, for example, Euronext had to lower its prices down to 40%. However, as Mr. Fleuriot underscores, the diminution of costs for the final investor is still to be demonstrated, in particular for non professional investors. The reason for this might be that the multiplication of trading facilities not only complicates the organisation of the system but also entails for investment services firm important investments in order to get access to these new markets, which explains the shift from cost savings for final investors to cost increase for investment firms. Moreover, issuers may also encounter extra cost (in comparison to the previous system) due to the leakage of the market information’s quality, as they cannot easily today get a hold on retrospective transactions’ prices, especially because the directive did not provide for any consolidation and recording of markets’ data and information (rather, the directive let the supply of information be organised by free competition). As for final investors, they seem to suffer from more fragmented and costly stock portfolios. Therefore, regarding the costs cutting issue for final investors, Mr. Fleuriot recommends that an investigation prior to the amendment of the directive be made, in order to measure the actual decrease of transaction costs and to assess more clearly the exact amount of every supplementary costs brought by the deregulation of markets.
Regarding market transparency and integrity, the deregulation of financial markets and the numerous new platforms both led to the decrease of the quality of transactions and of orders’ transparency. First, and especially because nowadays not all trading platforms are under the same regulatory requirements as regulated markets are, it is harder to check and assess all movements of capitals on no longer 14 but 24 facilities. Moreover, although the Directive only provided for the creation of MTF (close to regulated markets) and of systemic internalisers, other over-the-counter markets were implemented such as “crossing network” or “dark pools”, although not explicitly mentioned in the Directive.
In crossing networks, the intermediary internally matches his clients’ orders, in particular when institutions such as Goldman Sachs (Sigma X) or Morgan Stanley (MS Pool) have a sufficiently large clientele to meet its different orders internally. Crossing networks, as well as Dark Pools, are free to choose their clients, which is not the case for organised markets as they are only open to transactions brought by their members.
« Dark pools of liquidity », which also managed to fit into the directive’s scope, are organised platforms (regulated markets or MTF) using some of the directive’s exemption towards the pre- trading transparency information obligation. Different types of Dark pools therefore exist; they may differ based on the trading methodology by which the price is determined (determined in accordance with a reference price generated by another system, e.g. ITG Posit Now) or even can depend on the volume of the order (e.g. Turquoise).
This means that orders and transactions are completed without any prior publication of the price or the volume of the order (although they are made public afterwards –the same being true for crossing networks).
The issue raised by these new trading systems is that the use of the pre-trading transparency information waiver may become too widespread because of the ever increasing number of dark pools. Moreover, because “article 27 does not oblige systematic internalisers to publish firm quotes in relation to transactions above standard market size”, exemptions to pre-trading transparency obligation may become the rule rather than the exception if such unregulated markets become too numerous, and despite the fact that pre-trading transparency is deemed as essential in a deregulated system.
Therefore, should the number of dark pools or cross networking system increase substantially, this could hinder the subsistence of pre-trading transparency obligation, notwithstanding the fact that important volume of orders and transactions take place on these opaque markets. Moreover, this could put into question the legitimacy of the reference price imported from a regulated market and used by these dark pools when invoking this pre-transparency waiver. Indeed, in the end, the price of the market would be exclusively determined based on a very little number of transactions (those remaining and made on transparent and regulated markets). Even though only 10% of transactions already benefit today from this pre-trading opacity (regulated markets and most MTF still being under the pre-trading transparency obligation), the review of the directive should therefore take that risk into account.
Moreover, even though the post-trading transparency obligation has been extended by the Directive to all types of transactions, including those made over the counter, derogations to the immediate publishing of that information also exist (the information’s publication being delayed from 60 minutes to 3 days tops), that is when the deal is “done on own account and when the number and/or volume of orders sought by clients considerably exceeds the norm”. This leads to the temporary concealing to markets of important and voluminous transactions. Therefore, the objective of lowering trading costs and obtaining more market transparency may not yet be achieved.
Finally, the mere fact that MTFs (such as dark pools) or cross networking systems benefit from less restrictive rules than regulated markets do, raises questions on whether this privilege could be seen as unfair competition (a feeling emphasized by the fact that some regulatory market rules still differ from country to country). Indeed, one of the goals of the MiFID was to organise and implement competition between the different trading facilities, whether regulated or not. The harmonisation and application of the same organisational obligations to all kinds of financial markets or trading systems is therefore necessary.
Furthermore, another unfair competition problem is raised by the deregulation of markets regarding a certain type of company. Indeed, Small and medium Companies suffer from the heavy burden of certain regulatory constraints which, at the time they were drafted in 2004, were more tailored for important companies than small ones. The report therefore reckons that the costly and demanding regulatory framework implemented by the directive may have hindered the determination of small companies to enter or to stay on the public market (also because when the regulated markets’ deregulation occurred, new trading facilities naturally started to woo exclusively the most profitable issuers on regulated markets, i.e. the largest groups, rather than small and medium companies).
Mr. Fleuriot’s report does not only underscores the various market flaws brought by the deregulation of markets, for example that the investors can no longer, due to the numerous trading places in Europe, track down their stock’s movements and foresee price increases, he suggests pertinent improvements to it.
First of all, regarding transparency, Mr. Fleuriot suggests to adopt a trading model close to the American one, that is to say to create a consolidated data base which would put in common all information regarding orders and transactions made on all the different trading platforms. The new directive shall therefore be more descriptive regarding post-market operations information. Moreover, one of the elements which could participate to the improvement of market information would be the continuous gathering and recording of information issued by markets on a “consolidated tape”. The transposition in Europe of this Anglo-Saxon system to improve post-transactions information would ensure a better quality of the financial information and the reduction for final investors of the costs to access it.
Furthermore, such centralisation of information would work hand in hand with another important suggestion made by the Report, which is to increase the powers and prerogatives conferred to the soon to be EU securities and Market Authority (ESMA). Indeed, the live centralisation of market information would help improve the efficiency of the control that the ESMA is bound to operate on markets. With more post-operation information, ESMA would have more leverage to intervene in the definition and implementation of technical standards and in the resolution of conflicts between national regulatory agencies. Therefore, rather than putting into question the existence of this knotty trading markets’ system, which often raises differences in its interpretation, Mr. Fleuriot suggests to give to the ESMA the power to regulate and define price standards on the various issues which still raise problems.
Finally, one of the Directive provision imposes on new MTFs a best execution standard, which the report does not put into question per se, but suggests that it be clarified better. Indeed, the present definition of best execution only refers to ensuring “that investment firms execute client orders on terms that are most favourable to the client”. Whereas the US have a similar provision, which exclusively refers to a best price criteria, it appears that such a unique criteria may not be satisfactory. Indeed, the choice made by an investor in favor of one MTF at one point in time because it offers a better price than another platform may at the same time also be associated to a more important cost due to the choice of that first particular trading facility. Moreover, investors may prefer the European “best execution” standard to not only rely on price but also on a criteria such as one based on the speed of the order’s execution. There again, where the report does not recommend to repeal the “best execution” principle, it would rather see it consolidated and more precisely defined. This regulatory task could be put into the neutral hands of the ESMA which would define, precise and harmonise standards using the different criteria already suggested in the Directive (price, cost, speed etc).
All in all, the directive’s two main purposes, i.e. the opening to competition of financial markets and the lowering of costs consequently entailed, are not entirely challenged by Mr. Fleuriot’s report, but are still deemed to have participated to the creation of a complex multilateral system which needs above all a controlling, potent and influent authority to legislate, regulate, and settle implementation disagreements between national entities (through arbitration). Therefore, Mr. Fleuriot’s most important and insightful recommendation is to not only to implement the ESMA (already enacted by the Council but still under scrutiny by the Parliament) but to award it, through a Directive amending the regulation creating the ESMA (an “omnibus” directive) the widest prerogatives in order to be a credible and powerful European institution, necessary to a true internal market. –
 The option offered to countries by the 1993 Directive to decide to either deregulate or to keep a monopoly system for their national financial markets had been chosen by France, until the MiFID repealed it.
 So called when the intermediary systematically suggests himself to his client as counterpart.
 Source : Reuters, december 2009, cited by Rapport Fleuriot, 1.1.2, p.16
 Source : Oxera, based on a questionnaire. See Rapport Fleuriot, 1.2.2, p. 18.
 Rapport Fleuriot, Encadré n°1, p.13
Indeed, based on article 18 of Commission Regulation n°1287/2006, institutions such as Dark pools may benefit from an exemption to the pre-trade transparency information obligation. To benefit from the waiver, the trading system must be based on either of the following criteria: “ (a) they must be based on a trading methodology by which the price is determined in accordance with a reference price generated by another system, where that reference price is widely published and is regarded generally by market participants as a reliable reference price;
(b) they formalise negotiated transactions, each of which meets one of the following criteria:
(i) it is made at or within the current volume weighted spread reflected on the order book or the quotes of
the market makers of the regulated market or MTF operating that system or, where the share is not traded
continuously, within a percentage of a suitable reference price, being a percentage and a reference
price set in advance by the system operator; (ii) it is subject to conditions other than the current
market price of the share”.
 although dark pools and cross networking are different since dark pools are actually organised markets, cross networking are only systems made to confront the orders of an investment service provider’s clients : therefore, even though dark pools bathe in the directives’ provisions and may therefore rely on its exemptions clauses, crossing networking have developed almost out of the directive’s express provisions
 Art. 27 of MiFID: “In order to limit the risk of being exposed to multiple transactions from the same client systematic internalisers shall be allowed to limit in a non-discriminatory way the number of transactions from the same client which they undertake to enter at the published conditions. They shall also be allowed, in a non-discriminatory way and in accordance with the provisions of Article 22, to limit the total number of transactions from different clients at the same time provided that this is allowable only where the number and/or volume of orders sought by clients considerably exceeds the norm.”
 Rapport Fleuriot, 2.2.1, p. 30
 Rapport Fleuriot, 2.4.2, p. 33
 Rapport Fleuriot, 2.1.2, p. 26
 §3 of the MiFID Directive
 Rapport Fleuriot, p.24.