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Corporate Bonds

Editor's overview: MiFID II — enforcing virtue, risking sterility

MiFID II might qualify as one of the wonders of the modern world. At 1.5m paragraphs, including all its appendages, it swathes a blanket of mind-numbing verbiage around activities that were once fast and exciting.In that sense, it is the embodiment of modern financial markets and of modernity itself. By Jon Hay.

In the age of the Fitbit, the urge to measure and record every aspect of life has become ubiquitous. Economic progress has freed up time, and created technology, that we spend in this way. As selfies prove, we actually enjoy it.

But we are also striving to control and improve the activity measured — or at least, to stop anything bad happening. It doesn’t always work. We’ve all seen charts on the walls in McDonald’s toilets recording how often they are cleaned — and filth on the floor.

But the answer to any failing or scandal is always more checks, more controls.

MiFID II is not radical surgery for a crippled patient — more a rulebook telling healthy people how not to eat unhealthily, bump their heads or get ingrowing toenails.

For many practitioners in capital markets, the immediate effects will be a set of laborious procedures to go through, while carrying on the business as before. Allocations are a typical example. Equity and bond syndicate desks, together with issuers, decide which investors get fully allocated, which are scaled back and which get nothing.

The incentives are basically right: the issuer wants to reward investors it believes have helped get the deal done and will prove supportive in future. In a badly regulated system there would clearly be room for abuse: the banks could persuade the issuer to favour clients they wanted to please for other reasons. But that risk is already dealt with by the first MiFID, which makes banks have explicit policies on allocations, agreed with the issuer.

MiFID II means keeping extensive records of many of these allocation decisions, in case the regulator demands to see them, years later. What could go wrong? Conceivably, lawsuits from investors that felt short-changed, or investors being put off the primary market if allocations became too inflexible.

Unintended consequences

In other areas, MiFID II’s effects are much stronger, and the potential unintended consequences much more severe.

The most basic problem is that the great increase to the compliance burden MiFID imposes will bias the game further in favour of big firms, which can afford the staff to cope.

As our article on MiFID in the derivatives market shows, the US’s Dodd-Frank legislation was intended and expected to stimulate competition, for example by creating the new category of swap execution facilities — centralised venues for trading swaps. But the incumbents have refused to budge aside to let upstarts squeeze through to the trough. In fact, their behaviour has elicited lawsuits alleging that they are anti-competitive.

Five years on, hardly any new SEFs have got going.

In European derivatives, MiFID II has not even sparked the initial excitement that there might be business opportunities.

On the contrary, MiFID’s dead hand is expected to hang much heavier than Dodd-Frank’s, partly because of the less flexible way European regulators implement new laws. The sufferers will be small brokers, small trading venues. By trying to make the markets more competitive, MiFID risks choking competition.

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In fixed income, the same pattern is likely to play out (see pages 28-30). As one market participant told GlobalCapital: “There is no doubt in my mind that if you increase the regulation by an order of magnitude, then some small players won’t be able to cope, or won’t want to.”

Some side-effects are painfully absurd.

In its crusade to make sure no one is sold a financial product beyond the limits of their understanding, MiFID imposes a duty on banks to control whose hands a product ends up in, throughout its life. This could kill what is left of the retail bond market, already strangled by over-regulation. Meanwhile, anyone with a smartphone can trade contracts for difference or buy bitcoin.

In trading markets, some players sense opportunity. Because it loads a ton of extra reporting requirements on to traders, they will have to tool up with the latest software — and that could create an advantage for the most tech-savvy firms, which are trying to introduce new ways of trading.

Bond trading is on paper probably the market that could most benefit from updating — but some argue that its inherent illiquidity means darker, more opaque trading practices are actually better for clients.

In equities trading, the day of non-bank liquidity providers may at last be dawning. There is no reason why the main intermediaries have to be banks, and less capital-constrained players might do it better. But would they have the heft, and sense of responsibility, to cope with crashing markets?

Equity research is probably where the most radical and visible changes will happen (see pages 115-119). In a nutshell, fund managers will have to pay for research. The MiFID drafters imagine this means there will be a straightforward, properly functioning market, as for newspapers or books, where people buy what they want. It will be far from that. The big investment banks have huge incentives to keep their research flowing to clients.

How else to have the top ranked analyst teams? Whence comes — if not trading flow, the regulators’ old bugbear — investment banking mandates and a greater chance to make research pay for itself.

Investment banks, especially the big ones, will be able to flood the market with cheap research, undermining independent providers. For small asset managers, it will still feel like an extra cost, disadvantaging them, compared with big peers. And who will cover small companies? Perhaps only research firms paid by the issuers.

Hardly a triumph for competition and transparency.

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