to the Minister for the Economy, Industry and Employment · I would also like to thank Jean-Pierre Hellebuyck and Olivier Poupart -Lafarge ... Minister for the Economy, Industry

Report

to the Minister for the Economy, Industry and Employment

on

the Review of the Markets in Financial Instruments Directive (MiFID)

February 2010

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Madame Minister,

In submitting this report, I would like to take the opportunity to thank you for entrusting me with this task. I am aware of the importance of this task with regard to what is at stake for France and Europe in the Review of MiFID.

I would also like to thank Jean-Pierre Hellebuyck and Olivier Poupart-Lafarge for their participation in and contribution to this report, which is truly a collective effort.

I would also like to mention the critical contribution of the experts that supported us in our task, starting with Bénédicte Doumayrou, Department Head at the AMF (Autorité des Marchés Financiers), who has outstanding expertise in all these matters, as well as Frédéric Hervo, Department Head at the Banque de France and Thomas Lambert, Bureau Chief at the Directorate General of the Treasury, who both made a major contribution to this report. I would also like to thank all those who were kind enough to testify at our hearings and whose contributions provided critical information and inspiration for this report. Finally, I would like to thank our two rapporteurs, Maxence Langlois-Berthelot and David Lubek, Finance Inspectors, whose tireless work enabled us to compile this report.

I hope that the proposals in this report constitute a helpful contribution to the upcoming debate and to achieving our shared goal of an integrated European financial market.

Very truly yours,

Pierre Fleuriot

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EXECUTIVE SUMMARY

The Markets in Financial Instruments Directive (MiFID) was adopted on 21 April 20041 and came into force on 1 November 2007. It complements four other Directives adopted in 2003 and 2004 (Market Abuse, Prospectus, Takeover and Transparency Directives) and aims to create an integrated Europe-wide financial market, similar to the US market. MiFID defines a new market organisational structure by eliminating the concentration of orders in a single venue and by promoting competition between trading platforms to boost innovation and reduce execution costs. It lays down new pre-trade and post-trade transparency rules to ensure price formation in a newly fragmented market and relies on a “best execution” rule to protect investors that is binding on all intermediaries with regard to their customers.

The number of trading venues has increased since MiFID came into force and the competitive conditions have come in for some criticism at times. These venues provide services that are comparable to those of conventional regulated markets, which maintain the exclusive right to admit securities to trading. The arrival of the new venues, including 24 for trading equities2, has led to lower transaction costs and given rise to pan-European trading systems that make it possible to buy and sell securities admitted to trading in all Member States, which was impossible before. The new systems also promoted the creation of new clearinghouses, further driving down clearing costs.

On the other hand, it is hard to ascertain the impact that the new regulations have had on market liquidity because of the financial crisis and other changes that took place over the same period. The main changes have been brought about by technological innovation, which has radically changed the way orders are executed by facilitating algorithmic trading strategies and increasing the share of high-frequency trading. There is some debate about the role of high-frequency trading and the trade-off between increased liquidity, which makes markets more efficient, and the risk of some investors and financial intermediaries being squeezed out of the market.

It was foreseeable that the multiplication of trading venues and the fragmentation of liquidity would increase the complexity of markets; however, it was less foreseeable that it would also give rise to a prevailing feeling among various market participants that orders and transactions are less transparent. The increased cost of access to information and, more especially, the poor quality of post-trade data are areas where MiFID has failed. Issuers are particularly critical of the growing difficulty of tracking changes that affect their securities. End investors have not yet felt the benefit of lower unit execution and clearing costs, given the increases in certain costs (new technology, access to information, market complexity, etc.) and the reduction in the average size of transactions. Actually, cost savings are not always passed on to end investors, especially retail investors.

1 The “Level 1” Markets in Financial Instruments Directive (MiFID) was completed with a Level 2 implementing European Directive and Regulation, which were both adopted on 10 August 2006.

2 These are multilateral trading facilities (MTFs), which handle trades in equities that are already listed on a regulated market.

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The development of dark pools of liquidity, at the trading facilities’ own initiative in order to meet investors’ specific needs, and of crossing networks that intermediaries have set up since the entry into force of MiFID, which they use to match orders internally before sending them to the market, is helpful for block trades. On the other hand, the increasing volume of trading on these systems must not harm the price formation mechanism, which relies on transparent orders and trades. Therefore, orderly functioning of the market calls for dark pools of liquidity to be used only for the specific transactions that they are designed for. It also calls for crossing networks to be used within a future regulatory framework that includes disclosure requirements with regard to markets and regulators.

Three preliminary considerations underlie all of our proposals:

The first general observation that can be made on the occasion of the MiFID Review is that the quality of the information available for markets, issuers and regulators has not kept pace with developments on the markets affected by the Directive. The transparency principle is not enough: transparency needs to be organised. Therefore a sweeping review of the system is required to ensure the quality of trading information, even though market fragmentation makes it harder to gather. To this end, a specific review of trading information available to market participants, including issuers and to regulators is required, to ensure comprehensive and accurate dissemination/ publication of all transactions so that participants can track market activity. The information provided to regulators should also ensure that they can enforce existing regulations and assess the relevance of planned regulations.

The second priority is based on the observation that markets are continuing to undergo rapid and even sudden changes. This means that the regulatory system should be flexible and adaptable (third level rules or ESMA rules) to ensure its effectiveness in a constantly changing environment, given the role that technology now plays in market operations. Adequate regulation is not enough; it must be adaptable so that it can respond to the constant changes in the financial sector.

An integrated single European market calls for a central regulatory authority with real powers. The third priority calls for greater intervention powers and prerogatives at the European level (ESMA) to ensure that the rules are uniformly interpreted and enforced and to ensure a level playing field. These are prerequisites for a truly integrated market. The opportunity for creating such an authority has arisen with the drafting of the ESMA regulations and the adoption of an “Omnibus” Directive that sets out the scope of its powers.

The proposals in this regard are aimed more specifically at:

reinforcing transparency, as regards pre-trade transparency by limiting exceptions to the principle, and, as regards post-trade transparency by instituting a consolidated tape of for completed transactions. This will require the European regulator to stipulate technical standards and to ensure that infrastructure is implemented to ensure effective dissemination of the data;

levelling the playing field: for regulated markets and multilateral trading facilities (MTFs) through a review of the proportionality principle applying to MTFs, and through a requirement that MTFs inform to issuers when the issuer’s securities are traded on their platform; for organised markets and crossing networks, through the definition of the networks’ status, along with disclosure requirements with regard to markets and regulators; for dark pools of liquidity and transparent trading venues (regulated markets and MTFs), by setting a minimum size for orders in dark pools. Generally speaking, we should ensure that dark pools and crossing networks do not end up accounting for an excessive share of the market and “import” prices from transparent trading systems that handle only a small proportion of orders;

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clarifying the “best execution” requirement, without changing the definition used, but asking ESMA to define specific standards for the parameters mentioned in MiFID;

improving the contribution that markets make to financing the economy, by tracking the impact that the cost savings made in different links in the transaction processing chain have on the end investor and by implementing specific solutions to facilitate access to the European capital market for small and medium-sized enterprises;

strengthening the European regulator’s role, which includes overseeing the quality of the price formation process and maintaining a balance between the various market participants to ensure orderly functioning of the market and investor protection;

improving bond market transparency: the bond market is different from the equities market, but the transposition and adaptation of MiFID provisions regarding post-trade transparency would help ensure orderly functioning and make the market more attractive to investors, particularly when it comes to the valuation of their portfolios, without having a negative impact on market liquidity;

European post-trade harmonisation through a European initiative to complement MiFID. The report stresses the importance of harmonised post-trade activities (clearing and settlement) for the integration of pan-European financial markets and the importance of limiting systemic risks by granting all clearinghouses access to central bank money, by requiring them to be licensed as credit institutions, as is the case in France. This is a critical issue. It calls for the Commission to initiate regulatory changes by means of a suitable Directive.

* * *

The current review of MiFID is a critical step in building an integrated European financial market. This is a great opportunity to ensure it is a success, which is not quite the case today. The proposals in this report are meant to contribute to this success. They are based on a pragmatic and balanced approach. They are particularly aimed at giving the European regulator the means to shape the regulatory framework for the European financial market by strengthening its prerogatives and increasing the transparency and awareness of market activities.

The notion of balance features heavily in the report. The market is the meeting place and balancing point for many participants with different opinions and outlooks. This means it is important to ensure balance between the various participants. This report does not banish any of them from the market, but any abuse of a participant’s position will be to the detriment of the others. Balance is also required in the price formation mechanism for the trade-off between what is needed to fulfil the transparency requirement and what is acceptable for the sake of liquidity. Finally, balance is required to ensure financial stability: reducing prices is not the ultimate objective, since excessive price cutting can be harmful.

The regulator’s role is to monitor this balance, through its knowledge and ongoing oversight of day-to-day market operations and using means of action that ensure harmonised market regulation throughout Europe that can adapt as markets evolve.

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Other major debates will follow. This report does not deal with them because it seems premature to address them before completing the preliminary steps required to achieve true post-trade transparency (consolidated tape), an expanded role for the European regulator and unification of post-trade operations. Future debates will address the creation of a pre-trade consolidated tape, the potential transfer of fulfilment of the best execution requirement to the trading systems themselves and a simplification of the definition of best execution with regard to price. This will be the last step, but it is bound to involve other prerequisites, such as tax harmonisation, that go beyond the financial regulation framework. However, the infrastructure and players need more time to adapt to the faster pace of change as these coming steps are completed.

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CONTENTS

INTRODUCTION ........................................................................................................................................... 9

1. MEASURING PROGRESS ON AN INTEGRATED SINGLE EUROPEAN FINANCIAL MARKET TWO YEARS AFTER IMPLEMENTATION OF MIFID ............................................ 11

1.1. The objectives and main components of MiFID ........................................................................ 11 1.1.1. The objective of an integrated single European equities market ............................ 11 1.1.2. Establishing competition between equities trading systems ..................................... 12 1.1.3. Pre-trade and post-trade transparency rules ................................................................... 13 1.1.4. “Best execution” principle ........................................................................................................... 14

1.2. On balance, it is still difficult to establish an assessment, but complaints seem to outweigh the real benefits seen in several areas ...................................................................... 15 1.2.1. Competition between trading systems has given rise to a pan-European

equities market ................................................................................................................................ 16 1.2.2. Trading costs have come down, but the proportion of the cost savings

passed on to end customers is still subject to debate ..................................................... 17 1.2.3. Uncertain impact on liquidity ................................................................................................... 18 1.2.4. Increasing numbers of exceptions to pre-trade transparency .................................. 19 1.2.5. Poor post-trade transparency .................................................................................................. 20 1.2.6. A more complex post-trade environment ............................................................................ 21

2. PROPOSALS FOR THE REVIEW OF MIFID ................................................................................ 23

2.1. Enhancing pre-trade and post-trade transparency ................................................................. 24 2.1.1. Improving pre-trade transparency ........................................................................................ 24 2.1.2. Achieving genuine post-trade transparency by implementing a real-time

reporting system (consolidated tape) ................................................................................... 25

2.2. Improving competition between the different trading platforms ..................................... 27 2.2.1. Ensuring fair competition between regulated markets and MTFs.......................... 27 2.2.2. Recognising and regulating crossing networks ............................................................... 29 2.2.3. Revisiting the status of systematic internalisers .............................................................. 30

2.3. Clarification of the best execution principle ............................................................................... 30

2.4. Enhancing the role that markets play in financing the economy ....................................... 31 2.4.1. Measuring the effects of cost savings for end investors ................................................ 31 2.4.2. Improving the access of small and medium-sized enterprises (SMEs) to

capital markets ................................................................................................................................ 31

2.5. Asserting the role of the European regulator ............................................................................. 32 2.5.1. High-frequency trading ............................................................................................................... 32 2.5.2. Co-location ......................................................................................................................................... 33

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3. TRANSPARENCY ON THE BOND MARKET ............................................................................... 35

3.1. A market where MiFID transparency rules do not apply ...................................................... 35

3.2. A need for greater transparency after the crisis ....................................................................... 35

3.3. Using the review of MiFID to make the bond market more transparent ........................ 36

4. HARMONISATION OF POST-TRADE ACTIVITIES IN EUROPE ........................................... 37

4.1. MiFID does not deal with the lack of post-trade harmonisation in Europe ................... 37

4.2. Greater fragmentation under MiFID .............................................................................................. 38

4.3. Stepping up recent post-trade harmonisation initiatives ..................................................... 39

CONCLUSION .............................................................................................................................................. 41

APPENDICES: 1. Letter of engagement 2. Members of the task force 3. Witnesses 4. Glossary

Report to the Minister for the Economy, Industry and Employment on the Review of the Markets in Financial Instruments Directive (MiFID)

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INTRODUCTION

Directive 2004/39/EC on Markets in Financial Instruments (MiFID) entered into force on 1 November 2007 following a legislative process that lasted more than seven years. MiFID follows the Market Abuse Directive (2003), the Prospectus Directive (2003), the Takeover Directive (2004) and the Transparency Directive (2004). It is part of the European Commission’s Financial Services Action Plan (FSAP) aimed at creating an integrated European financial services market.

The most important provisions of MiFID include the elimination of order concentration rules, which allowed Member States, including France, that so wished to require orders to buy and sell shares to be matched in a single trading venue. In just two years, the new regulatory framework has allowed many new alternatives to conventional stock exchanges to emerge, making it possible to buy and sell listed securities at very competitive cost in all Member States. The Directive rapidly achieved two of the objectives set by its drafters: driving down unit transaction costs on equities markets and bringing forth the first truly pan-European trading systems.

On the other hand, the impact of MiFID on the liquidity and integrity of the equities market is the subject of some controversy. The equities market has also been affected by the financial crisis, albeit to a lesser extent than other markets. The crisis increased the volatility of securities prices and widened spreads, as major technological changes gave rise to new trading possibilities, such as high-frequency trading, which were unheard of in Europe only a few years ago. The impact of the Directive on market transparency has also been questioned, because of the increasing difficulty that players, including issuers, have in gathering information, and because of the exceptions to this transparency under the waivers allowed by the Directive and because of the persistently large proportion of over-the-counter trades carried out with no pre-trade disclosure.

In anticipation of rapid changes in the markets and the need to adapt regulations to the most innovative practices, European lawmakers stipulated that the European Commission should undertake a review of the Directive in 2010, three years after its entry into force.

In anticipation of this review, the Minister for the Economy, Industry and Employment tasked Pierre Fleuriot, aided by Jean-Pierre Hellebuyck and Olivier Poupart-Lafarge, to examine what could be learned from the financial crisis. They were also asked to identify the priorities for ensuring compliance with the European Union’s objectives regarding integration of financial markets in order to make these markets even safer, fairer and more focused on financing economic growth and jobs.

The work was to focus on four areas:

Enhancing market integrity

Increasing transparency in equities and bond markets and ensuring equal access to trading for all participants

Ensuring that all end users, without distinction, benefit from the best prices when trading

Reducing systemic risks and, more specifically, counterparty risks

The Minister’s letter of engagement asked the task force to evaluate the changes and decisions made since the Directive was adopted by the Parliament and Council of the European Union in April 2004 and to make proposals regarding market infrastructures, market operations and post-trade activities.


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The task force started its work at the beginning of November 2009 and completed it at the end of January 2010. It heard testimony from various players, including investors, issuers, intermediaries, trading facilities, post-trade infrastructures, economists and representatives of the supervisory authorities. The list of those interviewed can be found in the Appendix to the Report.


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1. Measuring progress on an integrated single European financial market two years after implementation of MiFID

1.1. The objectives and main components of MiFID

1.1.1. The objective of an integrated single European equities market

The Markets in Financial Instruments Directive (“MiFID”) expresses the European Commission’s ambition to create an integrated single European market for financial services. This ambition was set out in the 1999 Financial Services Action Plan (FSAP). It was based on the observation that the lack of an efficient European financial market penalised the European economy, compared to the United States, where a unified market has been in operation for several decades.

The FSAP sets out three objectives: 1/ create a single financial services market for institutional customers, 2/ make financial services markets accessible and safe for retail investors, 3/ modernise prudential rules and supervision. The entire legal framework for the European financial market underwent sweeping changes between 2003 and 2004 in support of these objectives, with the successive adoption of the Directives on Market Abuse, Prospectus, Takeovers, Transparency and Markets in Financial Instruments3.

In line with these objectives, MiFID aims primarily at:

Creating competition between the different order execution procedures on regulated and unregulated organised markets, as well as outside of markets

Harmonising and enhancing investor protection, especially when financial products are sold

Developing information-sharing and cooperation between regulatory authorities

On the other hand, the Directive deals with post-trade activities, meaning clearing and settlement, as merely a secondary issue.

The drafting of the Directive and the implementing measures gave rise to much debate4. Some of this debate may seem beside the point today, but it is still helpful to review the fundamental options in the Directive in order to understand the current debate about its implementation.

3 Directive 2003/6/EC of 28 January 2003 on insider dealing and market manipulation (Market Abuse); Directive 2003/71/EC of 4 November 2003 on the prospectus to be published when securities are offered to the public or admitted to trading (Prospectus); Directive 2004/25/EC of 21 April 2004 on takeover bids (Takeovers); Directive 2004/109/EC of 15 December 2004 on the harmonisation of transparency requirements in relation to information about issuers whose securities are admitted to trading on a regulated market (Transparency); Directive 2004/39/EC of 21 April 2004 on markets in financial instruments (MiFID).

4 If we count the transposition legislation, the whole process took more than seven years. The “Lamfalussy” procedure was first introduced as part of this process and then extended to banking legislation. The procedure distinguishes between four levels of regulation and supervision. MiFID, which was drafted jointly by the Parliament and the Council of the European Union, is at the highest level (Level 1). It is completed by implementing measures adopted by the Commission with the consent of the European Securities Committee (ESC) and in consultation with the Committee of European Securities Regulators (CESR) (Level 2). Technical opinions on implementation from national regulators, coordinated by CESR (Level 3). Level 4 represents the Commission’s enforcement of the legislation. The role of CESR (Committee of European Securities Regulators), which was set up by European Commission Decision 2001/527/EC of 6 June 2001, is to improve coordination among regulatory authorities at the European level and to act as an advisory group to assist the European Commission in drafting legislation. It is made up of representatives from all Member States, along with representatives of the Norwegian and Icelandic regulatory authorities and a representative of the European Commission.


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For the Commission, eliminating the regulated markets’ monopoly and creating authentic competition between different trading systems was the way to foster innovation and lower transaction costs. The draft Directive called for free competition between trading systems and between intermediaries. Countries, like France, that were attached to the principle of centralised order books, wanted measures to ensure transparency5 and investor protection, along with protection for the price formation mechanism in fragmented markets in order to provide a counterweight to open competition.

Therefore, the final language, adopted by the Parliament and the Council on 21 April 2004, which came into force on 1 November 2007, is a compromise between two concepts: a market that is open to competition, as it is in the United States, rather than the former centralised market, with pre-trade and post-trade transparency rules to create virtual matching of all of the buyers’ and sellers’ quotes in order to preserve the overall price formation mechanism.

Before giving an assessment of the implementation of MiFID, this report will attempt to present the main provisions of the Directive in three areas:

Establishing competition between equities trading systems

Extending pre-trade and post-trade transparency rules

Financial intermediaries’ obligations with regard to their customers under the “best execution” principle defined in the Directive

1.1.2. Establishing competition between equities trading systems

In order to enhance competition between trading venues and methods, it was no longer possible to maintain the principle of centralised order books: regulated markets and multilateral trading facilities (MTFs) may now compete freely. In addition, the introduction of “systematic internalisers” makes it possible to apply specific transparency rules to over-the-counter trades between such institutions and their customers.

The distinction between regulated markets and MTFs is now based on admission of securities to trading, where regulated markets still hold a monopoly.

Box 1: Regulated markets and multilateral trading facilities

According to the usual definition, organised markets are made up of regulated markets and multilateral trading facilities (MTFs). Only regulated markets have the power to admit securities to trading, which means that these securities can then be traded through the intermediaries that are members of the regulated markets. Admission to trading entails compliance with several other European Directives (Market Abuse, Prospectus, Transparency, etc.)

MTFs are multilateral systems specialising in trading securities admitted for trading on a regulated market. The may also handle securities that are not admitted to trading on a regulated market, as in the case of Alternext in France.

There are now 90 regulated markets and 133 MTFs in Europe, including 24 that handle shares admitted to trading on a regulated market. MTFs may also be managed by regulated markets (e.g.

Euronext Amsterdam manages NYSE Arca Europe) or by Investment Firms6 (IFs): Chi-X is an investment firm that is a subsidiary of the Instinet brokerage. Turquoise is an investment firm set up by a consortium of banks that was later sold to LSE.

Each of the Member States draws up the list of regulated markets. In France, the Minister for the Economy authorises regulated markets on the advice of the market regulator (AMF). MTFs managed

5 However, the transparency rules were restricted to the equities market.

6 Investment firms (IFs) include investment firms (L. 531-4 and following of the Monetary and Financial Code) and credit institutions authorised to provide investment services (L. 511-1 and following, and L. 321-1 and following of the Monetary and Financial Code).


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by a market undertaking or an Investment Firm also require the authorisation or approval of the national regulator. The regulators in France are the Autorité des marchés financiers (AMF) and the Comité des établissements de crédit et des entreprises d’investissement (CECEI).

Organised markets (regulated markets and MTFs) provide access to their members without discrimination, in accordance with rules that they draw up and disclose.

Box 2: Over-the-counter transactions (OTC)

The over-the-counter (OTC) market deals with transactions, such as direct transactions between buyers and sellers, that are not executed on organised markets.

MiFID provides for only one trading procedure on OTC markets, where the intermediary systematically acts as the customer’s counterparty, putting it in the “systematic internaliser” category. And yet, another practice known as “crossing networks” has developed since the Directive came into force. The Directive makes no provision for crossing networks, which intermediaries use to match customer orders internally. Some crossing networks have been developed by banks with large customer bases that provide a sustained flow of orders. Examples include Goldman Sachs (Sigma X) or Morgan Stanley (MS Pool). Other crossing networks have been set up by consortia of institutions. These systems operate by importing prices from the spreads on organised markets (regulated markets and MTFs). Investment firms acting as systematic internalisers or running crossing networks (see Box 6 for the definitions of crossing networks and dark pools of liquidity) are free to select their customers, unlike organised markets (regulated markets and MTFs), which are by nature open to all transactions executed by their members.

The OTC market also covers transactions made by direct agreement between two parties, without using any type of trading system whatsoever.

1.1.3. Pre-trade and post-trade transparency rules

MiFID introduces a harmonised transparency system on the equities market with the objective of enabling market participants to steer their orders towards the systems that offer the best prices and to scrutinise the terms on which their orders were executed. This leads to the distinction between:

pre-trade transparency rules, which mean that bid and offer spread is known at any given time. Consequently, an investor always knows the prices and volumes at which other investors are willing to buy and sell their securities.

Regulated markets and MTFs are subject to the same pre-trade transparency rules. Systematic internalisers are also required to publish prices for the securities that they make markets for in order to provide the market with information about prices and volumes.

Pre-trade transparency waivers (listed in Box 3) are granted to reconcile the principle of transparency, which is critical for investor confidence, with practices for preventing disclosure of block trades made using dark pools (see definition in Box 6) in order to limit the impact that such trades have on price formation. Liquidity is defined as an investor’s ability to carry out trades immediately without influencing price levels, which means that a completely transparent market is not always the optimum solution for all types of trades.


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post-trade transparency rules, dealing with disclosure of trades after their execution. This information is not used to execute orders directly, but to understand the execution terms. As a general rule, this information must be disseminated in real time after execution7.

In the post-trade phase, all trades are subject to the same transparency requirements as orders executed on organised markets (regulated markets or MTFs) or OTC trades. The only difference is that publication may be deferred depending on the nature of the trade (see Box 3).

Box 3: Transparency waivers provided for under MiFID

1. Pre-trade transparency

Pre-trade transparency waivers are granted in four cases (waivers set out in Articles 17 to 20 of Commission Regulation 1287/2006):

Execution based on prices imported from other systems

Block trades, in order to avoid the impact that such trades have on markets

Negotiated transactions. In this case the price does not result from matching all bid and offer quotes. Prices must be within the current volume-weighted spread reflected on the order book or the quotes of the market makers of the regulated market or the MTF, or be subject to conditions other than the current market price

Orders held in an order management facility pending disclosure to the market (iceberg orders)

2. Post-trade transparency

MiFID extended the post-trade transparency rules to all types of trades, including OTC transactions.

“Real-time” publication waivers for trades under the post-trade transparency principle consist of authorisation to defer publication (from 60 minutes up to 3 days) for large-scale trades executed on the institution’s own account. Such deferrals should enable the participant to close out its positions in order to reduce the market impact.

1.1.4. “Best execution” principle

The “best execution” principle is a key element of market functioning because it aims to ensure the best execution for the customer by seeking the trading system that offers the best price. The principle defines intermediaries’ obligations towards their customers when executing their orders. This principle is applied to all investment firms in the European area to enhance investor protection in a universe where intermediaries have a wide choice of order execution venues and methods. The criteria to be considered for retail and professional customers vary (see Box 4)8.

Box 4: “Best execution” principle

Investment firms’ business shall be governed by an “execution policy” for customer orders. The providers must be able to show that their policy is properly implemented. The “best execution” principle is a best-effort obligation that requires the investment firm to conduct its business in

7 Before MiFID, dissemination of post-trade data about listed shares was restricted to regulated markets in some countries, including data about off-market transactions. After MiFID, dissemination became the responsibility of investment firms, which can use the dissemination channel of their choice.

8 The “best execution” rule does not apply to “eligible counterparties”. An eligible counterparty is an entity that is authorised or regulated to do business on financial markets. Such entities include investment firms, credit institutions, insurance companies, UCITS and their management companies, commodities and derivatives traders, national governments and their corresponding offices, and central banks.


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accordance with the execution policy after obtaining the customer’s prior consent to the policy.

This rule applies to dealings with professional and retail customers, but not to dealings with customers choosing to be “eligible counterparties”, which is the status accorded to financial market players. The main criterion for retail customers is the total execution cost (sum of the security price and transaction costs), whereas the execution policy for professional customers weighs and ranks several criteria, such as price, execution times, the characteristics of the order and the nature of the execution venues. In any event, investment firms shall be deemed to have fulfilled their best execution obligation when they follow specific instructions received from their customers.

The best execution rule applies to all financial instruments. It offsets the effects that market fragmentation has on customers, particularly in the absence of links between the various trading systems. When intermediaries receive orders from customers, they have a choice of several execution systems and methods. The best execution rule should ensure that the intermediary makes its choice in the customer’s best interest and thus helps prevent conflicts of interest9.

This rule is not new in French law, but the requirements are much more detailed than before. The responsibility lies with the entity executing the orders, unlike American regulations, which make the trading systems themselves responsible for ensuring best execution. This requires American systems to be linked to the other systems to ensure that an order received by one of them is automatically routed to the system offering the best execution at that moment. Investment firms that transmit the orders received from their customers to other intermediaries for execution are bound by a separate “best selection” obligation with regard to the intermediary that they choose to execute their customers’ orders. After the orders are executed, the intermediary needs to be able to prove to its customers that it followed the agreed policy.

Ultimately, the best execution principle is applied by intermediaries to ensure that each of the orders received from end customers benefits from the most efficient execution, and the best price, with respect to the opportunities available on the market at any given time.

1.2. On balance, it is still difficult to establish an assessment, but complaints seem to outweigh the real benefits seen in several areas

It seems to be too soon to make an assessment of MiFID, primarily because its implementation is still very recent and it coincided with the start of the financial crisis in 2008. There have been major developments in financial markets since the Directive came into force. The financial crisis has had an immediate impact on market liquidity and volatility, and there have been substantial changes in technology in the space of a few years. This makes it difficult today to distinguish the role that changes to the regulatory framework have played in market developments.

Yet, we can say that the deregulation of trading methods under MiFID marked the emergence of a pan-European market, as the faster pace of change enabled various market players to seize new regulatory and technological opportunities in a newly competitive environment. MiFID overturned the conventional market framework, to the detriment of transparency, giving rise to complaints from regulated markets, which lost market share and revenue, from issuers, who suffered from a lack of information about trading in their securities, from certain investors, who feared that they would be penalised in a more fragmented market, and from certain financial intermediaries, who faced higher costs and increasing difficulties in doing business.

9 There are also order handling rules to prevent conflicts of interest between different customers (Article L. 533-19 of the Monetary and Financial Code).


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1.2.1. Competition between trading systems has given rise to a pan-European equities market

MiFID eliminated the Member States’ ability to maintain centralised order books on regulated markets, thus fostering the development of MTFs, which are either owned by investment firms or by the regulated markets themselves. Since MiFID came into force, the number of MTFs has risen from 14 to 24. But, if we strip out the Friverkehr that have long operated alongside the Länder stock exchanges in Germany, the number of MTFs has tripled, from 5 to 15.

The MTFs’ market share may reach a significant level. Together, they account for between 25% and 30% of trading in the leading listed shares10. However, four MTFs dominate the sector (Chi-X, Turquoise, BATS Europe and Nasdaq OMX Europe). Their growth has been uneven, depending on the stock indices. In December 2009 (see charts below compiled from Reuters data), the MTFs’ market share stood at nearly 40% of trading in FTSE 10011 shares, but slightly less than 30% of trading in CAC 40 shares and DAX 3012 shares.

FTSE 100

60,5

24,7

84,8

1,6

0

10

20

30

40

50

60

70

LSE Chi-X BATS Turquoise Nasdaq

OMX

Europe

CAC 40

70,3

20,1

4 3,9 1,8

0

10

20

30

40

50

60

70

80

Euronext Chi-X BATS Turquoise Nasdaq

OMX

Europe

DAX 30

73

18,9

3,8 3,3 1

0

10

20

30

40

50

60

70

80

Xetra Chi-X BATS Turquoise Nasdaq

OMX

Europe

S o u r c e : R e u t e r s , D e c e m b er 2 0 0 9 .

10 Source: Reuters, December 2009.

11 The FTSE 100 index includes the 100 largest market capitalisations on the London Stock Exchange (LSE). It is calculated by Financial Times Stock Exchange (FTSE), a company that specialises in calculating and disseminating stock indices.

12 The DAX index (Deutscher Aktien IndeX,) covers the 30 largest market capitalisations on the Frankfurt Stock Exchange (Deutsche Börse).

http://en.wikipedia.org/wiki/Deutsche_Boerse


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The trend seen in the second half of 2009 shows growth in the MTFs’ market share. However, it is hard to say if they can reach or even exceed the symbolic threshold of 50% of trading volumes. Regulated markets have managed to maintain their benchmark status, even though they now face some competition. It is noteworthy that the new MTFs have been set up by regulated markets themselves, as well as by investment firms. NYSE-Euronext started Smartpool and NYSE Arca Europe, NASDAQ OMX set up Nasdaq OMX Europe, and the LSE recently took over Turquoise.

The emergence of MTFs has led to the appearance of genuinely pan-European systems offering a range of securities from different European countries in a single system. This is a new development, because, despite all their efforts, conventional regulated markets never managed to produce such a system. Each regulated market maintained a dominant position for the securities that it had admitted to trading.

In addition, the new systems have implemented the latest electronic technology, giving them the same level of technological resources as regulated markets. Investment firms also offered new functions for managing complex orders and smart order routers to send them to alternative trading systems depending on certain parameters.

However, the MTFs handle only the most liquid securities and the new pan-European market does not include smallcap and midcap securities, which may end up being overlooked by MTFs, as well as by regulated markets.

1.2.2. Trading costs have come down, but the proportion of the cost savings passed on to end customers is still subject to debate

Lowering transaction costs was one of the primary objectives of MiFID. According to the Oxera study13 conducted on behalf of the European Commission, the average execution cost for a round-tripping transaction in the first three quarters of 2008 stood at between 0.25 and 0.30 basis points on MTFs, whereas dealing commissions on regulated markets ranged from 0.80 basis points (Deutsche Börse, LSE, Euronext) and 2.90 basis points (Greece)14. Consequently, regulated markets had to lower their prices substantially. Euronext dropped its prices by around 30% in 2008, with rate structures that favour users generating large trading volumes in order to attract liquidity.

Despite the price cuts observed, the issue of overall costs has not been resolved. Overall costs comprise direct costs, including post-trade costs, as well as indirect costs arising from market fragmentation. These indirect costs include changes in spreads15 (see 1.2.3. below), investment in technology and the additional costs stemming from the growing complexity of markets. Furthermore, the smaller average size of orders means that the lower cost per transaction does not necessarily translate into lower overall transaction costs, since a larger number of transactions have to be executed to trade a given volume of securities.

13 This Oxford-based consulting firm was founded in 1982. Governments and European institutions frequently call on its expertise in economic matters.

14 Julie Ansidei, Emmanuel de Fournoux, Pauline Laurent: Directive MIF : construire le marché financier européen, Revue Banque Éditions, 2007.

15 Difference between the best offer and bid prices.


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Ultimately, even though some intermediaries have lowered their own prices, end investors have not seen a reduction in their costs, especially in the case of retail investors16. Some investors underline the hidden costs of market fragmentation, insofar as fragmentation may lead to more missed opportunities because of the lack of connections to the most efficient trading systems.

The successful development of MTFs did not lead to a reduction in OTC trading. Therefore, MiFID’s success in increasing overall market transparency has not been an unmitigated one. The volume of OTC trading is generally estimated to be around 40% of all transactions. There is no answer yet to the question of whether MTFs have captured a portion of OTC trade flows.

1.2.3. Uncertain impact on liquidity

It is very difficult to assess the impact that the recent application of MiFID has had on liquidity given the scale of the events occurring during the financial crisis and the multitude of factors that are likely to affect liquidity. A closer look at this issue leads us to consider two debates: the impact of market fragmentation on liquidity and the role played by the development of new forms of algorithmic trading strategies.

The assessments of changes in spreads, meaning the differential between the quoted buying and selling prices for a security at a given moment, are contradictory. The FESE17 observed a widening of spreads in 2008 and 2009, while other observers found that they narrowed. In fact, spreads both grew and narrowed over the period. A study by the CFA Institute18 based on a sample of 44 stocks issued by Europe-based companies in the Dow Jones Stoxx 50 index shows that changes in spreads revealed a great deal of volatility, which is more closely related to the volatility of the underlying assets than the influence of the Directive per se. Spreads narrowed from November 2007 to January 2008, then widened from January to June 2008, before narrowing from June to September 2008. This was followed by a spectacular widening of spreads from September 2008, after the collapse of Lehman Brothers, to January 2009. After that, spreads narrowed. Ultimately, spreads narrowed slightly over the period as a whole. The key question is whether the widening of spreads between September 2008 and January 2009 was an exceptional event, which does not contradict the narrowing trend, or whether the key event was an increase in volatility, which doubled over the period from November 2007 to June 2009, compared to the period from the beginning of 2006 to November 2007. In this case, it would be unwise to conclude that there has been a lasting narrowing of spreads.

Ultimately, the CFA Institute study does not manage to establish significant correlation between spreads and market fragmentation. For example, spreads have narrowed more in the United Kingdom and France, which have the most fragmented markets in Europe. It is especially difficult to distinguish between the impact of market fragmentation, the impact of the financial crisis and the impact of technological change, with the development of high-frequency trading.

16 According to the Oxera questionnaire-based survey, average per transaction costs on the equities market fell by 33% between 2006 and 2008, while the transaction costs for the same value of securities traded increased by 9% (see Oxera study, pp. 70 and following). Average clearing and settlement costs fell from €0.35 per transaction in 2006 to €0.25 per transaction in 2008, a reduction of 28% (p. 87). However, these data do not address other expenses (research costs, market analysis, connection expenses, information systems, etc.) that are bound to be affected by market fragmentation, but are difficult to measure accurately.

17 Federation of European Stock Exchanges, which includes regulated markets and now includes MTF as well.

18 Centre for Financial Market Integrity (CFA Institute), “Market Microstructure, The Impact of Fragmentation under MiFID”, 2009.


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Box 5: Algorithmic trading and high-frequency trading (HFT)

Algorithmic trading consists of transmitting orders to the market on the basis of computer algorithms in order to obtain the best price, by splitting the order up over time and between several trading systems. It is used by buy-side investors, such as pension funds, asset managers and institutional investors, as well as by sell-side market participants, such as brokers, market makers and certain hedge funds. Algorithmic trading can by used for different investment strategies. The only characteristic common to all these strategies is the absence of human intervention when orders are sent to the market, even though human intervention may occur in the decision to buy or sell securities, particularly in the case of buy-side investors.

High-frequency trading is a subset of algorithmic trading strategies. These trading strategies are fully programmed and share the following features:

- very rapid execution, where the lag between the transmission of the order and its execution is a key factor for success;

- high frequency of trades;

- little or no exposed position at the end of the day.

The main high-frequency trading strategies are:

- market-making: orders are sent within the price range in order to capture the spread;

- instantaneous arbitrage between several trading systems when the prices for a given security are different;

- statistical arbitrage, which counts on mean reverting patterns when prices are statistically improbable (either for a given stock or in terms of the correlation between several stocks);

- event-driven strategies, which consist of placing orders as quickly as possible following announcements that affect prices, with automated interpretation of disclosure flows.

There has been debate about the impact of algorithmic trading strategies and, more specifically, high-frequency trading on market functioning and market liquidity. Some analysts maintain that high-frequency trading promotes market liquidity and efficiency, particularly in the case of arbitrage using algorithmic trading strategies. Other observers maintain that it has no impact on conventional investors, who hold securities for longer periods, and some observers feel that it actually harms market liquidity. The latter feel that a significant proportion of liquidity is not accessible to investors who do not have the most sophisticated technological tools. This report does not condemn algorithmic trading strategies, but it recommends that this activity be closely monitored to ensure that its development does not harm the interests of other market participants, such as brokers, who play a critical role in the orderly functioning of markets.

1.2.4. Increasing numbers of exceptions to pre-trade transparency

Debate about pre-trade transparency focuses on the issue of dark pools of liquidity and crossing networks (see the definitions of these terms in Box 6). These are two separate notions, which are sometimes lumped together under the single term “dark pools”. Both trading systems share a lack of pre-trade transparency, but they are different structures. As understood in this report, dark pools of liquidity operate on organised markets, whereas crossing networks provide internal order matching for the customers of a single investment firm. Dark pools developed within the framework defined by MiFID, relying on the waivers provided for under the Directive, whereas crossing networks are a more recent development that is not explicitly covered by the Directive.


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Box 6: Dark pools of liquidity and crossing networks

Even though MiFID does not address them specifically, dark pools of liquidity are covered by the regulatory framework established under the Directive. Dark pools are organised trading platforms (regulated markets or MTFs) that use the pre-trade transparency waivers provided for under the Directive. Orders are transmitted to dark pools without prior publication of the quoted prices, volumes and spreads. On the other hand, post-trade publication of the transactions takes place in accordance with the provisions of the Directive. Different types of dark pools are distinguished by the method used to set prices (imported prices: e.g. ITG Posit Now, block trades: e.g. Turquoise, or negotiated transactions: e.g. Liquidnet Europe).

Crossing networks are systems that match orders from customers of a single investment firm or of a group of providers operating a joint crossing system for their customers’ orders. Therefore, they have nothing to do with the initiatives of organised markets (regulated markets or MTFs). As is the case for all OTC trades, transactions executed via crossing networks are subject to post-trade publication in accordance with MiFID.

About half of the MTFs have set up dark pools of liquidity. There are currently nine of them in operation and most were set up after MiFID came into force. The new regulatory environment promoted the appearance of these dark pools, but they are nothing new. Regulated markets had long offered the possibility of executing block trades at a price within the current volume-weighted spread, and executing “iceberg” orders, where only a portion of the volume is disclosed. Regulators generally feel that MTFs have taken market share away from regulated markets in trade flows with pre-trade publication (“lit” markets), but the question as to whether dark pools have won a share of the flows previously executed over the counter, which was one of the MiFID objectives, has yet to be answered.

The share of orders executed through dark pools has not been determined precisely, but most published studies point to an increase in these flows.

The actual situation of crossing networks is also hard to ascertain. According to the most frequently cited data, they account for between 5% and 10% of OTC trades, or between 1.5% and 3.5% of all transaction flows. However, these data have to be taken with a grain of salt.

It is noteworthy that the increase in the numbers of registered systematic internalisers has been very small. Only thirteen investment firms have registered as systematic internalisers in Europe. A systematic internaliser is defined by MiFID as an investment firm which, on an organised, frequent and systematic basis, deals on own account by executing client orders outside a regulated market or an MTF. Observers have come up with different interpretations of this situation. The question as to whether the small number of systematic internalisers is a result of the limitations of the business model or a lack of clarity in the definition of the business in MiFID has yet to be answered.

1.2.5. Poor post-trade transparency

Before MiFID came into force, only regulated markets were subject to post-trade transparency requirements. The Directive extends the post-trade transparency requirements to all equities transactions, regardless of the trading procedure used. However, it is up to the regulated markets or investment firms that execute the trades to decide what dissemination medium to use.

The increase in the number of trading systems and the publication requirements with regard to investment firms’ OTC trades have led to an increase in the number of information sources and made it more difficult to access a consolidated view of market activity.


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The task force heard a great deal of testimony criticising the quality of post-trade transparency. The deterioration is most keenly felt in countries where the data were previously provided through regulated markets. More importantly, there is general agreement that data from organised trading systems are of better quality than the data on OTC transactions, which contain many errors (double counting, currency errors, delays, misplaced decimal points, etc.) Ultimately, issuers are dissatisfied about the problems that they encounter in tracking trading in their own securities.

Regardless of the quality of information, there is debate about the cost of accessing data with complaints about rising costs stemming from market fragmentation. A study by ESME (European Securities Markets Expert Group) published in July 2009 states that quantitative data do not confirm the presumed rise in costs, but that they do reveal that small and medium-sized players may be penalised.

1.2.6. A more complex post-trade environment

MiFID does not deal with post-trade activities, such as clearing, settlement, account keeping and custody19. However, it does have a real impact on post-trade activities, since the appearance of new MTFs has led to new clearing facilities and promoted the emergence of new players. The main new players include Euro CCP20, a subsidiary of DTCC21, a London-based clearinghouse used by the MTFs Turquoise and Smartpool22, and EMCF23, a subsidiary of Fortis, which is the clearinghouse for Chi-X and BATS. For the time being, the regulated markets are still using the same clearinghouses as before.

The emergence of new players has spurred price cuts of nearly 80%24 by clearinghouses, including those serving the regulated markets. Prices started to fall before MiFID came into force, but the decline accelerated as MTFs increased their market share. Despite the clearinghouses’ price cuts, several players point to the added costs of operating in a more complex clearing environment, which requires them to respond to many different margin calls and comply with different regulations.

Generally speaking, the impact of these price cuts, along with price cuts by regulated markets, need to be examined, not only in terms of their impact on end investors, but also in terms of their impact on the operating profits, investment capacity and risk management of the regulated markets and clearinghouses.

19 The Directive merely establishes investment firms’ and regulated markets’ right of assess to clearing and settlement infrastructure (See 4 below, which deals with pan-European post-trade harmonisation).

20 Euro Central Counter-Party.

21 Depositary Trust Clearing Corporation.

22 Solely for shares that are not listed on Euronext.

23 European Multilateral Clearing Facility.

24 Source: Banque de France.


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In 2006, the European Commission published a Code of Conduct for Clearing and Settlement in September 2006 with the aim of ending the compartmentalisation of post-trade activities stemming from differences in national regulations and stimulating competition by giving market participants a choice of clearing and settlement providers. The principles set out in the Code of Conduct meant that industry associations representing the markets, clearinghouses and central securities depositories were able to publish an Access and Interoperability Guideline in June 2007 that defines access and interoperability conditions for clearinghouses. The Guideline is a non-binding measure of confidence and goodwill between the signatories. However, requests for access must comply with the legal, tax and regulatory framework applying to the entities concerned. This explains why large numbers of interoperability requests have led to so little cooperation between the leading clearinghouses in practice. On the leading markets, only LSE offers a choice of two interoperable clearinghouses, LCH Clearnet and SIS x-Clear.

Ultimately, the fragmentation of clearing and settlement could generate risks because of the larger numbers of players in competition and the decline in their revenue, which could weaken their investment capacity. The increase in cross-border transactions fostered by MiFID, which has facilitated the development of post-trade activities in several Member States, and, more specifically, in a country other than that in which the trade took place, raises the issue of coordinated action between supervisory authorities in the event of a counterparty default.

Real advances were made following the entry into force of MiFID as regards stimulating competition, promoting technological progress and lowering trading costs, but trading volumes on European markets are still trailing far behind volumes on the American market. If we look solely at trading velocity25, the indicator for the United States still stood at twice the level reached by the European indicator26 throughout 2008 and 2009.

25 Velocity = trading volume / capitalisation.

26 The data used combine Europe, Africa and the Middle East (source: WFE, provided by UBS).


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2. Proposals for the review of MiFID

Financial markets have seen sweeping changes since the Directive came into force, with the impact of the financial crisis on market activity and recent technological developments. As we review the Directive, it is important to realize that these changes, particularly the technological ones, will continue to affect markets, and that other changes will occur that we are unable to foresee today.

Nevertheless, the assessment of its application, which is highly critical at times, does not call the Directive as a whole into question. The following proposals27 are aimed instead at revising some of the provisions of the Directive, in light of how its contents have been applied, to either supplement or amend these provisions to ensure that the regulations resulting from the review correspond more satisfactorily and more effectively with the objectives of the Directive, starting with the objective of creating an efficient and integrated single European market.

In this context, the recommendations highlight three priorities:

The first priority is to enhance the content and quality of market information as a necessary counterpart to opening up competition among trading platforms. This information is needed to maintain the confidence of investors and issuers, to protect the quality of the price formation mechanism and to ensure effective regulation.

The second priority relates to the need for adaptable and flexible regulations that enable us to respond to constantly changing market activities

The third priority is to strengthen the prerogatives of the European regulatory authority (European Securities and Markets Authority - ESMA) to ensure harmonised regulation and uniform enforcement of the regulations, which is the necessary corollary for a genuinely integrated single European market. The Regulation currently being discussed to set up the ESMA will have to be supplemented by an “Omnibus” Directive to delineate the exact scope of the new authority’s powers. Given the importance attached to European harmonisation of MiFID, when the negotiations surrounding the new Directive are under way, we should seek to endow the ESMA with the broadest powers possible to define technical standards (see below). Furthermore, we should ensure that the ESMA has sufficiently broad powers to arbitrate disputes between national regulators regarding the proper interpretation of the Directive’s contents.

In light of these three priorities, what follows is a discussion aimed at identifying the main areas where MiFID should be amended, along with proposals dealing either with the content of the amendments to be made or with the supplementary work needed to provide a clearer idea of the nature or the content of other provisions that should be included in the Directive.

The proposals deal with the following areas:

Enhancing pre-trade and post-trade transparency (2.1);

Improving competition between the different trading systems (2.2);

Clarifying the best execution principle (2.3);

Enhancing the contribution that markets make to financing the economy (2.4);

Asserting the role of the European regulator (2.5).

27 The proposals in this report deal only with provisions relating to the functioning of markets in securities admitted for trading and the various players contributing to these markets. It does not deal with the provisions for classifying investors into categories to provide them with better protection. The task force’s remit did not include this aspect.


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2.1. Enhancing pre-trade and post-trade transparency

Trade transparency is a critical component of market efficiency and integrity, which are prerequisites for ensuring proper price formation and maintaining investor confidence. At the same time, it should be possible to reconcile the transparency requirement with other requirements, such as limiting the impact that block trades have on the market, or encouraging intermediaries’ contribution of the liquidity needed to execute their customers’ orders by allowing deferred publication of transactions when they hold long or short positions.

This report takes a balanced approach that reconciles the need for transparency with the need for market liquidity.

2.1.1. Improving pre-trade transparency

The objective when dealing with the pre-trade transparency waivers provided for under the Directive should be to limit the volume of trading that does not contribute to price formation. The waivers under the Directive (see Box 3 above) may be helpful for the orderly functioning of the market, but they should not undermine its efficiency and the share of overall trading volume involved should remain small.

With this in mind, we looked at the use made of each type of waiver:

Execution using an imported price (a)

Execution of large-in-scale orders (b)

Execution of negotiated transactions (c)

Placing orders in an order management facility pending disclosure to the market (iceberg orders) (d)

In the same vein, this report has also examined the potential advantages of instituting a real-time reporting system (consolidated tape) to improve investor and market information. There is no such system at present.

a) Waivers for imported prices

Opinions vary about this type of waiver, which is presently applied to all orders, regardless of their size:

Some suggest eliminating this waiver, since its objective of limiting the market impact of executing an order should only apply to large orders, which are already covered by a specific waiver (see (b) below)

Others stress that such waivers are also useful for small orders. The purpose of using the waiver here is not to limit the impact on the market, but to execute orders at a price in the middle of the spread to the benefit of the buyer and the seller, in which case their individual interests prevail over the more general interest of ensuring liquidity in transparent markets and proper price formation.

The balanced approach recommended in this report is to enable efficient execution of large orders in multilateral trading systems, without an excessive reduction in trade flows on “lit” markets28. This approach means that we recommend maintaining the imported price waiver, but that a minimum order size should be applied and defined by the European regulator according to the liquidity of the security in question. The minimum size would necessarily be smaller than that applying to large-in-scale orders.

28 The term “lit markets” is used to distinguish trading systems with pre-trade transparency, as opposed to “dark markets”, where trades are executed under pre-trade transparency waivers.


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In the same vein, consideration could be given to suspending imported price trading systems when the transaction volume under pre-trade transparency waivers exceeds a threshold set by the regulator at the European level29 in order to protect the quality of the price formation mechanism. This proposal is aimed at maintaining the quality of the price formation mechanism on organised markets, but its implementation could raise a number of practical problems. It warrants further analysis, especially since excessive restrictions could trigger a transfer of transaction volumes to OTC markets.

b) The block trading waiver30

The reduction seen in the average size of trades31 executed on organised markets could lead to questions about the wisdom of lowering the threshold over which an order does not have to be disclosed by a regulated market or an MTF. However, lowering these thresholds would automatically increase the volumes of non-transparent transactions, which should remain exceptions to the rule. Therefore, this report does not favour lowering these thresholds.

It should be confirmed that these thresholds also apply to residual orders in the event of partial execution and not just to the initial order. This will prevent different treatment of two orders of the same size when one is a residual order and the other is a new order entered in the system’s order book.

c) Waivers for negotiated transactions

These transactions are traditionally granted pre-trade transparency waivers, which means that they are executed on an organised market that provides better quality post-trade transparency than the OTC markets where they might otherwise be executed.

d) Waivers for partially hidden orders in open systems

Under the current interpretation of the Directive, these waivers only concern iceberg orders and do not raise any special problems.

Some market participants have advocated the construction of a consolidated pre-trade order book modelled after the Consolidated Quote Plan implemented in the United States (see 2.1.2 below). This would provide a real-time display of the best bid and offer prices for European shares on all venues (regulated markets and MTFs) where the shares are listed (EBBO, European Best Bid and Offer, which would be equivalent to the NBBO, National Best Bid and Offer operating in the United States). The feasibility of an EBBO should also be assessed with regard to the liquidity of the participating trading platforms. Ultimately, such a system is bound to be useful, but it seems to be a secondary priority compared to the post-trade consolidated tape, which should be the primary focus of our efforts for now (see 2.1.2 below).

2.1.2. Achieving genuine post-trade transparency by implementing a real-time reporting system (consolidated tape)

Improving post-trade transparency is the priority for the review of the Directive. This transparency underpins the best execution principle and seems to be critical for maintaining investor confidence.

29 This threshold could be expressed as a percentage of total trading volume over a given period.

30 For orders that are “large in scale compared to normal market size”.

31 This trend stems from the development of electronic trading and started in the United States before the financial crisis. The average size of transactions on NYSE fell from 2,096 shares in 2000 to 531 shares in 2006 (source: NYSE Euronext).


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MiFID may provide for pre-trade transparency waivers, but does not provide for any post-trade transparency waivers whatsoever, since all transactions, including OTC trades, must be published regardless of the execution venue or method. And yet, post-trade transparency has run into implementation problems that mean it is not satisfactorily enforced.

In fact:

The multiplication of trading platforms publishing their post-trade data using non-harmonised technical standards makes it especially difficult to aggregate these data to provide an overview of the market

The published data have been roundly criticised for containing errors. The most frequent errors include double counting, unit and decimal errors, which can be detected easily in only the most blatant cases.

Gathering data from multiple sources increases the cost of acquiring information. The cost of accessing information seems to be substantially higher than in the United States, even though the information obtained is less accurate.

In the American market, data are aggregated in the form of a consolidated tape, providing a real-time flow of information through a cooperative structure made up of twelve trading systems32:

The Consolidated Tape Association was founded in 1974 to supervise the real-time transmission of pre-trade and post-trade data

This cooperative structure administers two systems:

the Consolidated Quote System (CQS) for pre-trade price quotes, which calculates the National Best Bid and Offer (NBBO)

the Consolidated Tape System (CTS) for post-trade data

The CQS and CTS receive data from each trading system33 in a standardised format; this enables them to display the NBBO in real time (for automated routing of orders to the trading platform offering the best price), along with the latest price and volume data from the Securities Industry Automation Corporation (SIAC), which distributes this information to market participants34

Transactions executed in dark pools of liquidity are reported within 90 seconds via the Trade Reporting Facility. Therefore all of the volumes executed on the various types of trading systems are published.

This report recommends transposing the post-trade part of this system to Europe to ensure higher quality information and lower information access costs for end investors.

The European regulator should start with measures aimed at improving the quality of the published data, which is a prerequisite for their consolidation:

Defining technical standards in conjunction with the industry to make published post-trade data clear and consistent

Further harmonising the interpretation of post-trade publication requirements35

32 The exchanges that joined the cooperative are NYSE, NYSE ARCA, AMEX, NASDAQ, BATS, Boston S.E., Philadelphia S.E., Chicago S.E., National S.E., International S.E; BATS has just joined, following its approval by the SEC as an exchange ; DirectEdge obtained the SEC’s approval in November 2009 and should join soon.

33 Meaning the exchanges and electronic communications networks (ECNs).

34 Some participants have chosen co-location of their servers in the SIAC data centre in order to reduce latency as much as possible.

35 The interpretation of the distinction between order execution and order reception-transmission has not be fully harmonised, which explains the differences in the nature of the information published.


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The publication deferrals allowed at present need to be re-examined in order to enhance the relevance of post-trade data. The longest publication deferral, which is currently three days, could be shortened to the end of the day, as was the case on a number of markets before MiFID came into force.

Once this prerequisite has been satisfied, there are two options for achieving a consolidated overview of the market. The great advantage of the first option is that it ensures concentration of information at a single point:

Setting up a single information concentration point, modelled after the existing system in the United States. Once a decision has been made on the principle of a European consolidated tape, the European regulator could draw up the specifications with regard to the objectives (content, access procedures, publication deferrals, etc.) Once the specifications have been defined, a call for tenders will be used to select the operator, without predetermining whether the operator will be from the public or the private sector.

This solution should involve all stakeholders. The issue of the cost of data also needs to be addressed. It is a sensitive issue, given its importance for regulated markets, which derive revenue from the sale of their data.

The other option is to maintain competition between data disseminators. In this case, disseminators must be given a deadline for achieving the objective. Furthermore, the aggregated data will only be of real benefit to market participants if their cost is not deemed to be prohibitive.

Finally, on a related matter, market fragmentation also makes it more difficult for the regulator to monitor activity in order to prevent market abuse (price manipulation, insider dealing). With the multiplication of trading systems, we must ensure that regulators receive comprehensive high quality information by:

Introducing harmonised customer identification codes;

Requiring MTFs to report the transactions executed on their systems to regulators.

2.2. Improving competition between the different trading platforms

2.2.1. Ensuring fair competition between regulated markets and MTFs

2.2.1.1. Issues stemming from MiFID

MiFID has created a harmonised regulatory framework for regulated markets and MTFs with regard to order execution, in line with the objective of opening this business up to competition, but there are still differences in the organisational requirements for regulated markets and the MTFs operated by regulated markets, on the one hand, and for the MTFs operated by investment firms, on the other hand.

The differences in the requirements stem from:


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The structure of the Directive: the organisational requirements for MTFs operated by investment firms are dealt with in the Articles on investment firms, without any specific reference in either the Level 1 Directive or the Level 2 Directive to the operation of a trading platform, whereas the requirements for regulated markets (and consequently for MTFs operated by regulated markets) are covered by more specific provisions36;

The application of the “proportionality” principle per se: as set out in the Directive, it deals only with investment firms and, consequently, with the MTFs that they manage. Under the terms of the principle, an investment firm “shall employ appropriate and proportionate systems, resources and procedures” to ensure continuity and regularity in the performance of investment services and activities.

This difference in the Directive’s approach has given rise to criticism from some players regarding a possible distortion of the competition between trading platforms in their common business of trading shares, depending on their status as a regulated market or an MTF operated by an investment firm.

An MTF operated by an investment firm has a lot more in common with an MTF operated by a regulated market, or even with the regulated market with respect to the organisation of a secondary equities market, than it does with any other investment service that the investment firm may provide. Consequently, it would be more consistent for MTFs, regardless of who operates them, to be subject to the same organisational requirements, since these requirements are unlikely to be fundamentally different from those applied to an equities trading platform operating as a regulated market.

The convergence of the requirements is all the more warranted at a time when the trading volumes on some MTFs are matching or exceeding the trading volumes on regulated markets for the same types of instruments.

Finally, it would be helpful to require MTFs to report trades executed on their platforms to the issuers of the securities traded. Even if admission to trading is not subject to the issuer’s prior authorisation, as some issuers wish, a reporting requirement seems perfectly legitimate and would enable issuers to monitor trading in their securities more easily outside of the regulated market where they were first admitted to trading. Regulated markets that admit an issuer’s securities to trading without the issuer’s consent should also be subject to the same reporting requirement.

Therefore, we propose:

Applying the same requirements to all MTFs, whether they are operated by investment firms or regulated markets;

Putting all the organisational requirements dealing with the regulated markets’ trading function37 in the same article of the Directive38 so that they apply to regulated markets and to all MTFs, while respecting the regulated markets’ monopoly for admitting shares to trading;

Making the ESMA responsible for ensuring harmonised enforcement of these requirements at the European level in order to prevent any distortion of competition;

36 The organisational requirements for regulated markets are set out in Article 39 of the Level 1 Directive and those for all MTFs are set out in Article 26. MTFs operated by regulated markets must also meet the requirements of Article 39 with regard to risk management, emergency procedures, etc., while MTFs operated by investment firms must comply with the requirements in Article 13 of the Level 1 Directive, which deals with investment firms. Articles 5 to 20 of the Level 2 Directive complete this Article and incorporate the “proportionality” principle.

37 Some of the requirements for regulated markets stem from their role as the primary markets and, consequently, they cannot be transposed for MTFs.

38 Instead of being split up between Article 39 (regulated markets) and Article 13 (investment firms), as at present.


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Requiring MTFs to report trades on their platforms to the issuers of the securities concerned. The same reporting requirement should apply to regulated markets that admit securities to trading without the issuer’s consent.

2.2.1.2. Issues stemming from other regulations

The objective of a level playing field for regulated markets and MTFs could lead us to deal with the issue of the fees charged by MTFs. This is a complementary aspect, which is not covered by MiFID.

A number of market players point out that the prices charged by some of the new MTFs could be construed as selling at a loss, even though this notion does not exist per se with reference to financial services. The argument is based on the observation that MTFs are not very profitable businesses, despite capturing a growing share of trading volume. We cannot say anything about these matters, which are not directly covered by MiFID. The parties concerned may refer their complaints to the competent authorities. However, the various players have to earn satisfactory profits to ensure sound competition. Excessive price-cutting by regulated markets or clearinghouses to cope with new competitors who do not seem to be making a profit would not be beneficial for everyone. It could also entail security risks and under-investment.

Of course, the profitability of the MTFs needs to be assessed in the longer term, given the scale of the initial investment required, but their lack of profitability must not be primarily justified by the benefits that accrue to their shareholders as a result of price cutting by regulated markets. The solution to this question should be found in the European regulator’s overview of the trading business, which will give an idea of the number of players that are likely to take up the business in Europe in the medium term.

2.2.2. Recognising and regulating crossing networks

Crossing networks’ share of transaction flows is estimated at 4% to 5% of OTC transactions, or around 1.5% of total transactions, but this proportion cannot be stated with any certainty for lack of reliable information sources.

The development of crossing networks or crossing systems, which MiFID makes no provision for, raises several issues. In contrast to MTFs, which are open to all investors, the banks operating crossing networks are able to select their customers. Furthermore, these trading systems are not subject to the same rules as systematic internalisers and MTFs with regard to imported prices or pre-trade transparency waivers. The crossing network mechanism may also lead to questions about conflicts of interest between investment firms and their customers and between customers.

Therefore, we recommend recognising and regulating these trading systems that are not covered by MiFID. This will require:

Prior identification by the regulator, using a specific code to monitor trading volumes on the system over time

Submitting the price importing rules to the regulator (these rules should be aligned with those of MTFs), along with the processes aimed at ensuring best execution

Prior notification of the customer about the potential nature of the counterparty for the execution of orders in the event where the institution itself is allowed to be the counterparty. This issue has not been resolved and current practices will have to be identified in order to examine the potential solutions.


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Placing a limit on the volumes traded on these trading systems (the SEC limits trading volume to 0.25% of total trading volume for a given security in order to uphold the principle of fair access). The limit should be determined by the ESMA. In order to handle volumes in excess of the limit, the crossing network will have to become an MTF to uphold the principle of equal access to the market39, and it will have to comply with the pre-trade transparency requirements applying to MTFs.

2.2.3. Revisiting the status of systematic internalisers

When MiFID was being drafted, the status of systematic internalisers was seen as a major advance for transparency, but it has had little success, so little in fact that there are questions about whether there is any point in maintaining it.

However, nobody is proposing that the regulations be eliminated, since this type of business has its specific uses, even though it attracts few takers. Systematic internalisers are not in the same business as MTFs, which provide services to outside customers, or as crossing networks, which match customers’ orders with other customers’ orders.

This report recommends an examination of the rules applying to systematic internalisers in order to make them more consistent. More specifically:

Quotes should be given for both sides of the offer-bid spread and not just the one-sided quotes40 currently allowed under the Directive

To prevent quotes for volumes that are too small to constitute a significant contribution to liquidity, systematic internalisers should be required to quote prices for a minimum volume of securities to be set by the ESMA41

Such rules would make the status of systematic internaliser more consistent but they would not necessarily make it more attractive to intermediaries.

2.3. Clarification of the best execution principle

The MiFID provisions dealing with best execution raise interpretation difficulties that complicate its implementation and supervision of compliance:

The number of parameters to be considered (for professional investors: price, cost, speed, likelihood of execution and settlement, size and nature of the order) makes it difficult for intermediaries to apply this principle properly in practice. There is some diversity in the interpretation of the requirements:

Some intermediaries claim that the use of smart order routers ensures the best choice of trading platform at all times

Other intermediaries offer best execution centred on the choice of single trading system, which is generally the regulated market where the security is listed

39 Some intermediaries, including Nomura and Cheuvreux, have already turned their crossing networks into MTFs.

40 Some systematic internalisers present predominantly one-sided quotes, which were originally intended to be an exception rather than the rule. See CESR report dated 10 June 2009, Impact of MIFID on Equity secondary market functioning, 3.2.2.

41 Some systematic internalisers display prices that are valid for trades involving a single share. Consequently, these prices are not significant (see CESR report dated 10 June 2009, p. 17).


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Best execution centred on obtaining the best price for the individual transaction would not ensure the best total price, since clearing and settlement systems in Europe are not unified, as they are in the United States. The choice of an MTF offering a price improvement of one basis point at a given instant could entail additional costs of several basis points linked to the choice of the trading platform itself. Furthermore, there are legitimate reasons why professional investors may prefer other criteria to execution speed.

This is a complex environment that is in contrast to the American regulations, where the best execution obligation is based solely on the price of the transaction and where the trading systems themselves, and not the intermediaries, have to fulfil this obligation by automatically routing orders to the platform offering the best price, with a single clearinghouse and settlement system.

Best execution is a key factor for unifying the market. It ensures that the fragmentation of execution among several trading systems does not mean that orders are executed at anything other than the best price possible, given the state of the market at a given instant.

This report recommends leaving the current definition of best execution as is, but making it more operational by asking the ESMA to define detailed and harmonised standards for the different parameters mentioned in the Directive (price, cost, speed and likelihood of execution).

2.4. Enhancing the role that markets play in financing the economy

Two points are particularly worthy of special attention with regard to the impact of MiFID on investors and issuers: passing on cost savings to the end investor and ensuring access by small and medium-sized enterprise to capital markets.

2.4.1. Measuring the effects of cost savings for end investors

Competition between trading platforms under the terms of MiFID is not an end in itself. The Directive aims to lower the previously high costs on regulated markets, compared to the prices on American markets, and to stimulate innovation. We can say that the latter objective has been achieved. However, end investors do not seem to have benefited from the cost savings on fees charged by trading systems, which the Oxera report commissioned by the European Commission estimates have fallen by 33% since 2006. Some intermediaries reply that the cost of connecting to different trading platforms and the cost of developing smart order routers mean that they are unable to pass the transaction cost savings on to their customers. Other intermediaries report that they have lowered their prices by 15% to 20%.

In anticipation of the review of MiFID, it would be helpful to measure the Directive’s impact on end users’ transaction costs for a more accurate assessment of the actual impact of lower transaction costs, and to measure the additional costs stemming from the complexity of the system in order to measure the potential and actual price cuts for end investors, today and in the future.

2.4.2. Improving the access of small and medium-sized enterprises (SMEs) to capital markets

Regulated markets had to lower their transaction fees as a result of the competition between trading systems. Consequently these markets sought out other sources of revenue and made efforts to reduce their operating costs. Several witnesses stressed the impact that these developments have had on listed SMEs:


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The cost of admission to trading went up significantly, even though the amounts concerned are unlikely to affect the profitability of the companies concerned42

Fewer staff members were devoted to providing assistance for companies, which has had the most impact on small companies that do not have enough of their own staff

This report notes the concerns expressed about the future access of SMEs to the capital market, in a context where the competition between trading systems focuses on the largest capitalisations. It observes that access for small and medium-sized firms and midcaps to market financing is a specific public policy objective that involves a great deal more than just the review of MiFID.

It is a key issue for financing the economy and developing growth businesses. It is likely to be examined separately, since it touches on many other issues, such as relaxing the requirements for admission to trading and prospectus contents, adapting accounting standards for small and medium-sized enterprises in light of the proportionality principle, promoting special investment vehicles aimed at SMEs, and setting up pan-European trading platforms specialising in small and medium-sized enterprises’ shares so as to concentrate the liquidity of these shares. The Minister of the Economy, Industry and Employment gave Fabrice Demarigny the task of coming up with a proposal for a stock exchange “Small Business Act” for Europe. His findings are expected at the end of February and they will make a major contribution to this European debate.

2.5. Asserting the role of the European regulator

An integrated single European market calls for a European regulator with the resources to monitor activity closely so that it is able to design effective and adaptable regulations, and with sufficient powers to exercise regulatory oversight.

Its key tasks should include ensuring the orderly functioning of the markets, especially with regard to the quality of the price formation process, and fair competition among the various trading platforms, along with investor protection and financial stability. The equities market has not been a source of special concern with regard to financial stability, but that does not mean that it should not be kept in mind, especially when analysing price-cutting by trading platforms and clearinghouses, or the distribution of trading volumes by the type of players operating on the market.

This report is based on the principle that orderly functioning of the market ensures that the market is a meeting place for a multitude of players with different opinions, interests, roles and time horizons. In principle, no individual category of player is blameworthy per se, but it is wrong for one category to enjoy a dominant position to the detriment of the others. Therefore, it is the regulator’s job to ensure a proper balance among the various market participants at all times.

The approach that this report proposes for high frequency trading and co-location strategies illustrates the balance being sought.

2.5.1. High-frequency trading

Opinions diverge on arbitraging strategies based on high-frequency trading, which financial intermediaries may execute on their own account or which investors themselves, such as hedge funds, may execute:

42 The maximum cost is limited to €50,000 per year for all companies. The cost for an average sized company is around €20,000 per year (source: {0><}98{>Middlenext).


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Some observers stress the contribution that these strategies make to market liquidity and efficiency by unifying prices across different trading systems and quickly eliminating any extraneous prices. These same observers point out that these strategies are in line with arbitragers’ regular efforts to seek out new opportunities;

Other observers stress the excessive share of trading volumes attributable to these strategies and the risks associated with purely mechanical order systems, yet fail to back their criticism up with any technical arguments43.

According to the explanations provided by high-frequency trading practitioners, their gains are made at the expense of brokers, who make profits by capturing the spread44.

In practice, three types of measures could be considered:

Limiting the decimalisation of tick sizes, but this could lead to wider spreads, which would not be good for investors;

Imposing a “minimum latency” for order transmission. But such a measure seems to be difficult to enforce in practice;

Regulating the fees charged by trading systems, which are considered to favour high frequency trading because MTFs and regulated markets remunerate short-term “passive” or resting orders since high frequency trading contributes to liquidity. The remuneration lowers unit transaction costs regardless of volumes and promotes strategies based on executing large numbers of orders over a short period.

There does not seem to be any need for the European regulator to take such measures at this time. Yet, this report recommends that the regulator analyse and monitor high-frequency trading activity in order to be ready to intervene with such measures if abuses occur.

2.5.2. Co-location

The quest to reduce latency to a minimum extends to “co-location” of high-frequency traders’ and their intermediaries’45 computer servers inside the trading systems to ensure faster transmission46 of orders. Co-location also provides additional revenue for trading systems, which charge participants rent for their slots. However, this practice raises the issue of equal access to the market.

Co-location advocates point out that trading systems have enough slots to accommodate every intermediary that wants one. It should also be noted that markets have often allowed certain players to be located closer to the central market, especially when they are asked to make a special contribution to market liquidity (brokers on the trading floor in Paris and specialists at the New York Stock Exchange).

43 High-frequency trading strategies seek to exploit temporary price inconsistencies. They tend to cause prices to revert to the mean and, consequently, they cannot destabilise the market. They should not be confused with the trend-following strategies that some hedge funds use. These strategies actually accentuate the trends and could contribute to the formation of bubbles. Trend following strategies, which lend themselves to fully automated trading, result in profits over a much longer timeframe.

44 Narrower spreads also benefit investors. This means that the brokers’ losses are shared between high-frequency traders, who are the main beneficiaries, and investors.

45 Sponsored access arrangements enable high-frequency traders to transmit their orders to the market directly, under the sponsorship of the intermediaries.

46 500 microseconds.


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Co-location must not be confused with the practice of flash orders, which consists of allowing some participants to view orders a few milliseconds before they arrive on the market so that they can know about them before they become public. This practice does not exist in Europe yet. It was developed by certain American trading systems and is now being dropped because it allows the beneficiaries to transmit their orders before information becomes public, which constitutes front-running47.

This report does not oppose co-location, but it does recommend that the ESMA monitor its development and gauge its impact48 before deciding what the appropriate measures are, if any. The report recommends that, at the minimum, action should be taken to ensure equal access to co-location for all market participants.

In a similar vein, the ESMA should ensure that the practice of naked sponsored access, which allows investors direct access to the market with no pre-trade validation by the intermediary, does not develop in Europe, in view of the risks that it poses for financial stability. Similarly, the ESMA should reject flash orders, which may have been allowed in the United States, but do not seem to comply with the principle of equal treatment of investors.

47 The SEC has announced its intention to ban the practice.

48 The SEC recently announced that it is starting consultations on the impact of co-location (see the letter from Mary L. Schapiro to Senator Kaufman, 3 December 2009).


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3. Transparency on the bond market

The transparency rules under MiFID do not apply to the bond market (3.1). And yet, the financial crisis revealed the need for greater transparency on this market (3.2). Therefore, the review of the Directive could be an opportunity to introduce provisions for enhancing the transparency of the bond market (3.3).

3.1. A market where MiFID transparency rules do not apply

All of the provisions of MiFID apply to the bond market, except for the transparency rules, which apply only to shares admitted to trading on a regulated market.

On the bond market, OTC transactions account for 90% of the volume, which means that the MiFID rules for regulated markets and MTFs do not apply to transactions in corporate bonds. The situation may be different for government bonds, for which trading platforms exist49.

Recital 46 in the Directive stipulates that Member States are free to apply pre-trade and post-trade transparency requirements to financial instruments other than shares. In practice, though, only two Member States, Italy and Sweden, have availed themselves of this option so far.

Article 65 of the Directive calls for the European Commission to carry out a public consultation on the possible extension of the scope of the provisions of the Directive concerning pre and post-trade transparency obligations to transactions in classes of financial instrument other than shares. This consultation was carried out in 2006 and did not lead to any change in the provisions of the Directive dealing with bond markets. In its April 2008 report, the Commission noted that there did not seem to be any need to change the European regulations in this area.

3.2. A need for greater transparency after the crisis

The financial crisis also had an impact on the corporate bond market. The period before 2007 featured very narrow corporate spreads and satisfactory trading conditions. However, the liquidity crisis in 2007 and 2008 led to a shutdown of the primary corporate bond market that lasted for several weeks and made it difficult to obtain benchmark prices for trades and valuations on the secondary corporate bond market.

Under the circumstances, CESR revised its 2007 findings at the request of the European Commission and indicated in June 2009 that an orderly bond market required greater post-trade transparency.

Market players acted on their own to examine how greater transparency could be achieved on the bond market. In France, the market players met within the framework of Paris Europlace to look at what would be required to set up a European platform for executing bond trades in 2010.

49 For a comprehensive analysis of the secondary bond market, see the report by Mr Hoenn and Mr Pinatton published by the AMF in December 2009: http://www.amf-france.org/documents/general/9253_1.pdf.

http://www.amf-france.org/documents/general/9253_1.pdf


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3.3. Using the review of MiFID to make the bond market more transparent

In keeping with the proposals made in the report that Mr Hoenn and Mr Pinatton submitted to the AMF Board, our report recommends following up the industry consultations under way with amendments to the MiFID provisions dealing with transparency, thus promoting a harmonised approach throughout Europe.

The transparency rules should be adapted in consideration of the specific features of the bond market, even though the crisis has shown that we need to improve the way the market works, including during times of great stress. We need to make the market more liquid and more transparent, especially for the purposes of making portfolio valuations.

Pre-trade transparency should be encouraged, but the priority objective is to enhance post-trade transparency.

The new post-trade transparency rules to be incorporated into the Directive should apply to all trading in bonds where issuance resulted in the publication of a prospectus and to bonds traded on MTFs, regardless of whether the trades are executed on regulated markets, MTFs or even over the counter. The practical procedures will require in-depth work on publication times and the details of the information to be published on volumes and prices so as not to weaken the market liquidity provided by market makers. As is the case for transactions in shares, the post-trade data should be available at a reasonable and non-discriminatory cost to all investors.


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4. Harmonisation of post-trade activities in Europe

Progress on the objective of an integrated European financial market is being hampered by the fragmentation of post-trade infrastructures, which has increased since the entry into force of MiFID. The result is higher costs for cross-border transactions than for domestic transactions and potential risks for financial stability. The situation in Europe is in contrast to the situation in the United States, where clearing on the equities market is provided by a single entity, the Depository Trust and Clearing Corporation (DTCC). Harmonisation of post-trade infrastructure is a critical component of market unification in Europe after MiFID.

4.1. MiFID does not deal with the lack of post-trade harmonisation in Europe

Post-trade activities include the functions that take place after trades are executed to settle the trades and administer the financial instruments traded:

The clearing function with a central counterparty provided by a clearinghouse (CCP) calculates the net position of each operator resulting from the clearing flows and acts as the sole central counterparty for sellers and buyers. Clearing reduces liquidity requirements for cash and securities, and the central counterparty limits the risks.50

The cash payment and the delivery of the securities result in settlement of the transaction. Settlement is generally provided by the central securities depository (CSD), which is also responsible for the notary function of keeping the issuers’ accounts and providing safekeeping for assets on custodians’ accounts. The central securities depository makes sure that the number of securities on the issuer’s account matches the number of securities on the custodians’ accounts at all times.

The rules governing the organisation of this infrastructure differ within the European Union and the differences are hampering integration of financial markets. The Giovannini Report commissioned by the European Commission identified 15 obstacles to market integration back in 2001. These obstacles relate to technical specifications and market practices (interface technology, settlement times) and to legal and tax procedures.

MiFID takes a minimalist approach to post-trade activities that provides for51:

The right of investment firms and regulated markets to access clearing and settlement infrastructure in another Member State

The right of members of a regulated market to designate their settlement system

However, there are restrictions on these rights: the free choice of settlement systems for members of regulated markets is subject to conditions relating to technical aspects and preserving financial stability52, and CCPs and CSDs are entitled to refuse access to investment firms “on legitimate commercial grounds”.

On the other hand, MiFID does not contain any provisions dealing with harmonisation of national post-trade systems. These still differ in many areas:

Business models: some operators prefer vertical integration of functions from the regulated market to settlement (Deutsche Börse), with others prefer horizontal cross-border integration (Euronext for trading, LCH Clearnet for clearing, Euroclear for settlement)

50 The risks are concentrated on the CCP.

51 Articles 34 and 35 (right of access for investment firms) and Article 46 (right of access for regulated markets).

52 The competent authority needs to confirm that the settlement conditions offered by another CSD “are such as to allow the smooth and orderly functioning of financial markets”.


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Governance: CCPs and CSDs may be user-governed, user-owned cooperative structures (LCH Clearnet) or they may be listed companies or subsidiaries of listed companies (Deutsche Börse) with their own profit objectives.

Finally the national regulatory and supervisory systems are different and post-trade service operators cannot obtain a European passport or mutual recognition.

Taken together, these factors result in:

Additional technical and legal costs for cross-border transactions; the average cost of cross-border clearing is twice as high as the cost of domestic clearing, and custody costs are seven times as high53

Disparate risk levels: France’s Monetary and Financial Code requires CCPs to be authorised credit institutions, which gives them access to central bank money in the event of a liquidity problem; this is not the case in all countries and, more specifically, in the United Kingdom. The new clearinghouses that have emerged since the entry into force of MiFID do not all present the same guarantees (see below). In the same vein, differences in CCP practices with regard to settlement create distortions in recourse in cases involving short selling.

4.2. Greater fragmentation under MiFID

The fragmentation of post-trade infrastructure stems from the national frameworks that existed before MiFID, but it has increased since the Directive entered into force because of two factors:

The emergence of new market players that were initially responsible for clearing transactions executed on MTFs (see charts in the appendix);

Commission initiatives (Code of Conduct) aimed at promoting competition among clearinghouses in order to bring prices down.

The prices charged by the pre-existing equities clearinghouses have fallen by 75% to 80% in three years: the average cost per transaction at LCH Clearnet has been cut from €0.20 to €0.06554.

However, the multiplication of clearinghouses has also led to additional costs:

Investors who use several trading systems for the same securities face larger margin calls because they cannot offset the different transaction flows, since each regulated market or MTF has its own clearing house

The frequent use of intermediaries55 to overcome the technical and regulatory barriers to access to settlement systems in other European countries leads to additional costs that are not taken into consideration when comparing clearinghouse fees alone. The Oxera study estimates that the custodians’ share of the value chain is four times greater than that of CCPs and CSDs. This means that assessing best execution on the basis of the transaction price alone is only a partial solution, since the choice of a trading system offering a better price in another country could ultimately entail a higher total cost;

The multiplication of clearinghouses makes it impossible to realise the potential economies of scale associated with this activity, which primarily involves fixed overheads for computer systems and legal structures. The total post-trade costs on the cash equities market are eight times higher than in the United States, where all of the clearing is handled by a not-for-profit, user-owned and user-governed entity.

53 Source: Oxera study, Monitoring prices, costs and volumes of trading and post-trading services, July 2009, pp. 85-86.

54 And as little as €0.02 for highly liquid securities.

55 Except for the largest investors, which have local subsidiaries that they can use for direct access to all of the clearing and settlement systems.


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The multiplication of clearinghouses may also raise problems with regard to financial security:

Differences in national supervisory systems create the risk of regulatory shopping by clearinghouses, since the lowest costs are associated with less stringent risk control

The multiplication of CCPs diminishes the effectiveness of the risk reduction associated with the principle of clearing per se, since the clearing involves a smaller base of transactions

That fact that some clearinghouses56 do not have access to central bank money could be a problem in the event of a counterparty default.

4.3. Strengthening recent post-trade harmonisation initiatives

Several European initiatives are aimed at attenuating the negative effects of post-trade fragmentation:

The recommendations of the ESCB57 and CESR are aimed at harmonising the post-trade regulatory and supervisory framework by adapting international standards to the European context. The joint work of these two bodies was completed in 2009 and resulted in non-binding recommendations addressed to authorities. The impact of their work was limited by the lack of harmonisation concerning the status of post-trade players.

The ECB Governing Council announced in 2006 the “Target 2 – Securities” initiative, which is aimed at integrating the cash and securities settlement functions in a common platform58 run by the central banks to replace the existing national securities accounts systems. This would mean that CSDs would focus on their notary functions as central depositories. The system should start operating in mid-2013 and it will be open to currencies from outside the euro area.

Until recently, the European Commission’s approach has been based on self-regulation and promoting competition:

Following the 2001 and 2003 reports of the Giovannini Group, a strategy for removing barriers to the integration of post-trade infrastructure was defined, which distinguished between the responsibilities of national authorities59 and those of market players60. Progress has been slow because the recommendations are non-binding and because of the costs which harmonisation entails.

56 Such as EMCF, which is the clearinghouse for two of the leading MTFs (Chi-X, BATS), which has access to settlement in commercial bank money only.

57 European System of Central Banks.

58 Based on the large-value euro payment system “Target 2”, which the central banks already operate.

59 FISCO (expert group on tax compliance matters) dealing with tax barriers, and LCG for legal barriers.

60 Clearing and Settlement Advisory and Monitoring Expert group (CESAME): 6 barriers to harmonisation identified.


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Following a proposal by the European Commission, the industry federations (FESE, EACH61 and ECSDA62) signed a Code of Conduct on 7 November 2006, aimed at promoting fair competition through transparent pricing, interoperability and unbundling of services to give customers freedom of choice. In practice however, it is still hard to compare prices, and interoperability is still an unresolved issue.

In its Communication dated 20 October 2009, the Commission announced a European legal initiative for the end of the first half of 2010, with implementation to follow by 2012 at the latest. The objective is post-trade harmonisation in Europe, both for derivatives (after the financial crisis highlighted the risks stemming from the lack of clearing for these products), and for cash markets, with the objectives of greater competition and interoperability, along with the additional objective of maintaining financial stability. The instrument will have to go into great detail to reduce differences of application among Member States.

This report recommends supporting these initiatives and advocates:

The use of the access to central bank money as a criteria for assessing the security of clearinghouses in order to contain systemic risks; such access is guaranteed in France, where clearinghouses must be granted credit institution status

Full harmonisation of regulatory requirements and technical standards to facilitate integration of clearing in Europe

User-governed CCPs, modelled on the American DTCC. This model encompasses attractive pricing policies and financing for the investment needed to develop new services and to modernise the CCP’s IT resources.

A single European clearinghouse for each class of products would achieve economies of scale and genuine harmonisation. Partial consolidation of existing clearinghouses now seems possible, given the poor profitability of some of them (and of some MTFs). Global consolidation is an objective to be pursued in the longer term.

61 European Association of Central Clearing Houses.

62 European Central Securities Depositories Association.


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CONCLUSION

The entry into force of MiFID triggered a genuine revolution in the organisation of Europe’s financial markets. Some of its effects have been criticised in France, such as the decline in transparency stemming from market fragmentation, but MiFID severely challenged the French tradition of a centralised market running a single order book, with full transparency and non-discriminatory access.

The Directive eliminated this market structure and allowed competition between trading platforms under conditions that were criticised in some cases. However, it also had some positive effects, such as reducing transaction and clearing costs, even though we still need to ensure that the savings are actually passed on to end investors. It also made it possible for pan-European equities trading platforms to emerge, but we still need to ensure that this does not harm small and medium-sized intermediaries and that it does not restrict small and medium-sized enterprises’ access to the European capital market.

In the newly fragmented environment, orderly and efficient markets call for enhanced transparency, which is critical for preserving the quality of the price formation process and ensuring investor protection under the best execution principle. It should soon be possible to use standards defined by the European regulator (ESMA) to improve post-trade transparency by setting up a consolidated database.

Most importantly, the European financial market calls for a European regulator, with broad powers and flexible means of action to underpin an integrated conception of the market through unified application of the regulations to pre-trade and post-trade activities.


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APPENDIX I

Letter of engagement Pierre Fleuriot, Chairman of Crédit Suisse France 25, avenue Kléber 75784 Paris Cedex 16 Paris, 28 October 2009

Dear Mr Chairman, The financial crisis was more than just a banking crisis. The shock wave that it generated revealed problems in several critical markets in financial instruments. In its action to recast international financial regulations, the G20 stressed the need to enhance market integrity. It also called for clearing for trading in certain types derivatives in order to reduce systemic risks, provided that the infrastructure is sufficiently robust. At the same time, the crisis led to greater concentration of intermediaries on international financial markets. The European Union had to cope with a double shock because the crisis came in the wake of the sweeping regulatory and industry changes triggered by the entry into force of Directive 2004/39/EC on Markets in Financial Instruments (MiFID) on 1 November 2007. The Directive eliminated the rules on centralisation of orders that enabled European countries to require the supply and demand for shares in listed companies to be matched in a single venue to ensure an efficient market. For the finance industry, this measure led to a multiplication of the trading platforms and systems for financial instruments, and growth of over-the-counter transactions. MiFID automatically spurred competition between platforms, which led to a large drop in the cost of their services. The decline in unit transaction costs, along with technological advances, led to strong growth of algorithmic trading, which now accounts for a significant proportion of trading volumes, especially on certain platforms. The multiplication of trading platforms and systems resulted in a fragmentation of liquidity between a large number of platforms and systems. In this new and more complex environment, only a limited number of intermediaries seem to be able to have an overview of the market and a global approach that enables them to execute their transactions under the best conditions. For other operators, the complexity of the best execution rules and the fragmentation of the markets have resulted in higher costs. Europe has also seen the development of new trading venues, such as dark pools of liquidity in the form of multilateral trading facilities (MTFs) or crossing networks. The impact of these developments on market transparency and the efficiency of the price formation mechanism have yet to be gauged. Finally, harmonisation of trading conditions for financial instruments in Europe, with no comparable move to harmonise post-trade activities, could raise operational problems that increase risks and costs.

* * *


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In 2010, the European Commission will initiate a review of MiFID. Following the decisions of the G20, the Commission will also have to take initiatives regarding the OTC markets. I would like these initiatives to be an opportunity for Europe to apply the lessons learned during the crisis with respect to financial markets. In practical terms, I shall ensure that Europe moves in the direction of the public policy objectives that the Government has set with respect to financial markets. For the European Union, this means building an overall vision in the coming years of what constitutes safe and fair financial markets that provide sustainable financing for economic growth. First of all, I would like market integrity to rank as the leading objective. After that, transparency on the equities and bond markets needs to be enhanced and we need to ensure that all participants have equal and transparent access to trading. Widely available information in useable form is the best way to ensure efficient price formation for financial instruments that is grounded in the fundamentals of the real economy and that helps companies and investors. I would also like to improve end users’ access to the best prices. The regulations must not place certain players in a position to obtain better prices. Finally, the elimination of systemic risks, and, more specifically, counterparty risks, through appropriate clearing of trades is a critical priority. In anticipation of the European review, I have decided to charge you with the task of assessing the developments and decisions made since 2004 and putting forward with proposals regarding market operations, with a focus on equities and bond markets. Jean-Pierre Hellebuyck and Olivier Poupart-Lafarge will contribute to your work. I urge you to involve as many different market participants as needed (investors, issuers, intermediaries, trading platforms, post-market infrastructure), as well as anyone who can shed significant light on these issues (economists and academics, representatives of supervisory authorities and legal professionals). I would be grateful if you could submit your findings and your proposals to me by 31 January 2010. Yours sincerely, Christine Lagarde


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APPENDIX II

Members of the task force Commission Pierre Fleuriot, Chairman, Crédit Suisse France Jean-Pierre Hellebuyck, Investment Strategy Manager, AXA Investment Managers, Member of the Board, Autorité des Marchés Financiers (AMF) Olivier Poupart-Lafarge, Chairman, OPALIC, Member of the Board, Autorité des Marchés Financiers (AMF) Technical experts Bénédicte Doumayrou, Head, Department of Intermediation and Market Infrastructure Regulation, Autorité des marchés financiers (AMF) Frédéric Hervo, Head, Supervision of Payment and Securities Settlement Systems, Banque de France Thomas Lambert, Head, Savings and Capital Markets Bureau, Directorate General of the Treasury, Ministry of the Economy, Industry and Employment Rapporteurs Maxence Langlois-Berthelot, Finance Inspectorate David Lubek, Finance Inspectorate


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APPENDIX III

Witnesses David Angel, Manager, ITG Chris Bates, Partner, Clifford Chance LLP Roland Bellegarde, Group Executive Vice-President, NYSE Euronext Arnaud de Bresson, Managing Director, Paris Europlace Dominique Carrel-Billiard, CEO, AXA IM Nick Collier, Executive Director, Morgan Stanley Patrick Combes, Chairman, Groupe Viel Fabrice Demarigny, Global Head of Capital Markets Activities, Mazars Graham Dick, European Business Development, Chi-X Sylvain de Forges, Risks and Markets Manager, Veolia Environnement Thierry Foucault, Professor, HEC Jeff Gooch, CEO, MarkitServ Carole Gresse, Professor, Université Paris Dauphine Jean-Pierre Grimaud, Chairman, Af2i Judith Hardt, Secretary General, FESE Christophe Hémon, CEO, LCH Clearnet SA Brad Hunt, Managing Director, Goldman Sachs Denzil Jenkins, Director of Regulation, Chi-X Alexander Justham, Director of Markets, FSA Catherine Langlais, Executive Vice-President, NYSE Euronext Paul-Henri de La Porte du Theil, Chairman, AFG Pierre de Lauzun, CEO, Association française des marchés financiers (AMAFI) Vivien Lévy-Garboua, Special Adviser to the Chairman, BNP Paribas Joël Mérère, Executive Director, Euroclear


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Gérard Mestrallet, Chairman, Paris Europlace Ariane Obolensky, CEO, FBF Philippe Oddo, Chairman, Oddo & Cie Bertrand Patillet, Deputy CEO, CA Cheuvreux Michel Pébereau, Chairman, BNP Paribas Michel Péretié, Head of Investment Banking, Société générale Gilles Petit, Deputy Head, Savings and Capital Markets Bureau, Directorate General of the Treasury Jean-Pierre Pinatton, Chairman of the Supervisory Board, Oddo & Cie Michel Prada, former Chairman, AMF Rainer Riess, Managing Director, Deutsche Börse Xavier Rolet, CEO, London Stock Exchange Bertrand de Saint-Mars, Deputy CEO, Association française des marchés financiers (AMAFI) Mike Sheard, Director of Corporate Affairs, ICAP Jean-François Théodore, Deputy CEO, NYSE Euronext Jean Tricou, Manager, Investment Banking Department, Fédération bancaire française (FBF) Edouard de Vitry, Managing Director, UBS Duncan Wales, Group General Counsel, ICAP Caroline Weber, CEO, Middlenext Eddy Wymeersch, Chairman, CESR


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APPENDIX IV

Glossary

Algorithmic trading: transmitting orders to the market on the basis of computer algorithms in order to obtain the best price, notably by splitting the order up over time and between several trading systems. It is used by investors, such as pension funds, asset managers and institutional investors and hedge funds, as well as by intermediaries, such as brokers and market makers. Algorithmic trading can by used for different investment strategies. The only common characteristic is the absence of human intervention when orders are sent to the market, even though human intervention may occur in the decision to buy or sell securities.

Best execution rule: standing obligation for financial intermediaries who execute buy and sell orders involving financial instruments to make every effort to obtain the best possible result for their customers when executing their orders. This requires intermediaries to consider different factors that will enable them to obtain the best possible result: total cost, speed of execution, likelihood of execution and settlement, size and nature of the order “or any other consideration relevant to the execution of the order”. The “best execution” principle is a best-effort obligation that requires the investment firm to conduct its business in accordance with the execution policy previously approved by the customer. Investment firms are deemed to have fulfilled their best execution obligation if their customers give them specific execution instructions.

Crossing network: an automatic system for matching buy and sell orders internally between an investment firm’s customers. Orders are “crossed” without being transmitted to regulated markets or MTFs. Investment firms set up crossing networks when they handle large flows of customers orders that can be crossed internally. These systems operate by importing prices from the spreads on regulated markets and MTFs.

Dark pools of liquidity: organised trading platforms (regulated markets or MTFs) that use the pre-trade transparency waivers provided for under MiFID. Orders are executed in dark pools without prior publication of the quotes from buyers, sellers or intermediaries. On the other hand, post-trade publication of the transactions takes place in accordance with the provisions of the Directive. Several types of dark pools can be distinguished according to the price setting procedure used (imported prices: e.g. ITG Posit Now; block trades: e.g. Turquoise; negotiated transactions: e.g. Liquidnet Europe).

Flash orders: practice of allowing some participants to view orders a few milliseconds before they arrive on the market so that they can know about them before they become public. To date, this practice does not exist in Europe. It was developed by certain American trading systems. It is being phased out because some observers deem that it allows the beneficiaries to transmit orders before information becomes public, which constitutes front-running.

High-frequency trading (HFT): a subset of algorithmic trading strategies. These trading strategies are fully programmed and they all rely on very rapid execution, where the “latency” between the transmission of the order and its execution constitutes a critical factor for success, high frequency of trading and a net opening and closing positions that are null or minimal.

Multilateral trading facilities (MTFs): specialised multilateral platforms for trading securities admitted to trading on a regulated market. Managing an MTF requires authorisation or approval from the national regulator (Autorité des marchés financiers in France). Like regulated markets, MTFs provide access to their members without discrimination, in accordance with the rules that they draw up and disclose.

Over-the-counter (OTC) markets: markets where transactions are made by direct agreement between the buyer and the seller, without going through regulated markets or MTFs.


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Regulated market (RM): a multilateral system which brings together multiple third-party buying and selling interests in financial instruments admitted to trading in the system and in accordance with non-discretionary rules. Only regulated markets have the power to admit securities to trading, which means that these securities can then be traded through the intermediaries that are members of the regulated markets. Each of the Member States draws up the list of regulated markets. In France, the Minister of the Economy authorises regulated markets on the advice of the market regulator (AMF).

Sponsored access: direct access to the market for an investor, with or without prior validation of orders by the intermediary (naked sponsored access).

Systematic internaliser: an investment firm which, on an organised, frequent and systematic basis, deals on own account by executing client orders outside a regulated market or a multilateral trading facility.

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to the Minister for the Economy, Industry and Employment · I would also like to thank Jean-Pierre Hellebuyck and Olivier Poupart -Lafarge ... Minister for the Economy, Industry