Financial regulation plays catch up with crisis

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The European Commission has proposed extending the Markets in Financial Instruments Directive (MiFID) to redress market abuse and volatile trades highlighted by the financial crisis. Experts warn that arbitrage is always around the corner.

"It's probably unnecessary to point out that the week we are going through is a decisive week for Europe. I think … we are showing that we are finding a response to the crisis," Michel Barnier, the EU Commissioner for the internal market said at a press conference yesterday (20 October).

The commissioner yesterday announced a series of measures to prevent high-frequency trading from causing volatility in markets and to stamp out abuses in a host of trades and platforms which have emerged since 2003.

He was also referring to a summit of EU leaders being held this coming Sunday to stem the rising tide of sovereign debt.

The financial crash in 2008 unveiled a swathe of financial practices which by definition circumvented regulation and have subsequently been identified as causing market distortions, such as high-frequency trading.

MiFID upgrade

The Markets in Financial Instruments Directive (MiFID), which yesterday received an upgrade, aims to dampen the kind of trading that is carried out by automated platforms based on momentary price swings within the space of 2-3 seconds. For example, traders will not be allowed to withdraw from trades immediately, causing price disruption.

Many blame the original MiFID's narrow scope for giving rise to such trading and warn that traders will always find a way to sidestep EU regulation.

"MiFId has opened up markets but it has not dealt with arbitrage," Bob Penn, a financial lawyer at the London branch of Allen & Overy told EURACTIV.

Many also blame MiFID for the emergence of so-called Dark Pools – trades that are concealed from the public – and Broker Crossing networks, which take business away from stock exchanges.

The Commission said yesterday it will attempt to drive these trades onto a new platform category, an Organised Trading Facility, to create a more level playing field, more transparency and less volatility.

In an early sign that the Commission's co-legislator, the European Parliament, will lobby for a stricter MiFID, the French Green MEP, Pascal Canfin argued the proposals did not address the fragmentation of the equity market in Europe and the development of 'Dark Pools.'

Canfin argues that the EU is in danger of legalising trading that should be eliminated.

In addition the EU also announced that all countries must impose mandatory criminal sanctions for insider trading and market manipulation.

Clamping down on market abuses

In an upgrade to the Market Abuse Directive, countries will have to extend these sanctions to a range of trades that have become market makers in recent years, such as over the counter commodity derivatives and carbon credits. Commodity derivatives have in the past had a detrimental effect on world food prices.

The Commission does not outline how tough sanctions should be in spite of earlier rhetoric in December 2010 on putting traders convicted of market abuse in jail.

An EU official said it will review the situation in four years and impose concrete sanctions if none have emerged at a national level.

Bob Penn doubts that harmonisation of sanctions is possible as these are often cultural.

"It will be an uphill battle persuading regulators and law enforcement authorities to act in the same way," Penn said.

He cites an example from 2008 when Porsche had secretly been buying Volkswagen shares, making the company one of the largest globally. At the time, Porsche was eyeing a merger with VW.

In the UK this would clearly have counted as market manipulation, while in Germany it did not, Penn pointed out.

Pointing to gaps in the Commission's review of MiFID, Guido Ravoet, the Chief Executive of the European Banking Federation said: “We think that the Commission’s proposal for Organised Trading Facilities (OTF) is likely to need adjustments if this trading venue is to serve current investors’ needs”.

The Global Association of Investment Professionals, the CFA Institute, the Investor' lobby EuroInvestors and the Federation of European Securities Exchanges issued a joint statement calling for: The transparency and consolidation of trade data for all financial instruments; A level playing field in trade execution for all market participants; Direct access of individual investors to capital markets by reducing the overall complexity and costs of investing; and consistency with other legislation.

Sony Kapoor, a former Lehman Brothers' trader and founder of the Re-define think tank said: “No matter how much the Commission denies it, the mushrooming of new trading venues, high frequency traders and dark pools and the exponential increase in the number of transactions were at least partly the unintended consequences of the original MiFID legislation.”

On a more positive note, Kapoor commented that “the new transparency regime for bond, structured products and derivative markets and the enhanced data collection regime is a giant leap of regulatory reform.”

"The review of the equity markets provisions should address the concerns investors have that technology is outpacing regulation. The proposals on fixed income and other asset classes could really shake up the bond markets so we must tread carefully so as not to cause a loss of liquidity at this crucial time," read a statemenet from Dr. Kay Swinbourne, a British MEP from the European Conservatives and Reformists group

The Greens were less enthusiastic. "Regrettably, however, the Commission missed an opportunity to close some of the other key loopholes in MIFID. The proposals should have gone further as regards defragmenting the equity market in Europe. The fragmentation of the financial market in Europe and the development of 'Dark Pools', facilitated by the original MIFID rules, leads to major inefficiency. The Commission has also failed to take strong enough steps to clamp down on food speculation. Food markets should not be left to the whim of speculators, yet these proposals will definitely not put an end to speculation on food commodities," Pascal Canfin, a French Green MEP said yesterday. 

The Markets in Financial Instruments Directive (MiFID), a cornerstone of the EU's Financial Services Action Plan, was proposed in November 2002 to update the existing Investment Services Directive (ISD) of 1993.

The law was designed to cope with, and to further enable, an increased number of cross-border investment transactions.

It aims to set a comprehensive regulatory regime, impose higher standards and include commodities derivatives. It therefore seeks to produce greater European harmonisation of laws and encourage capital market integration in the EU.

The law was adopted in 2004 and replaced the EU's Investment Services Directive in 2007.

  • The draft law is now being passed on to the European Parliament and EU Council of Ministers for adoption.

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