Mifid II

What is MiFID II?

It's a complicated set of rules, running to 1.4 million paragraphs (!), governing how finance works in the European Union. Seven years in the making, Mifid II was agreed in 2014 and took effect on January 3, 2018.

Wait - wait - bear with me. I know what you're thinking. You're thinking this has no bearing on your life. For people who aren't in finance, delving into the details of something like Mifid II probably seems about as fascinating as reading the fine print on one of those endless software user license agreements you have to click on to use a piece of corporation-generated freeware, or watching paint dry.

However, the reality is that finance pretty much rules the world - including how we treat each other, how we treat the biosphere (and its courageous defenders), and everything else. It's the financial system and its rules that decide how and for what purposes  money, credit and debt are generated, shunted around, accumulated, distributed, and gamed. So, arguable, the financial system and its rules determine how your life is shunted around and gamed.

So why not take a couple of minutes to gain at least a vague idea of the revised rules our betters in Brussels have set up to fine-tune the engines of financial capitalism. Spoiler alert: They haven't built in any new rules that would constructively change our relationship to the biosphere, or would solve poverty. They've mostly just tried to make it a bit harder for finance professionals to run scams on investors. 

What MiFID II is

Let's get some jargon out of the way first.

MiFID II stands for "European Union Markets in Financial Instruments Directive II." Its predecessor, MiFID I, came into force in November 2007, shortly before the great financial crisis of 2007-8. Mifid II is a revamped version of the 2007 Directive, meant to address shortcomings revealed by the financial crisis. And there were lots of those, weren't there?

MiFID II, according to ESMA (European Securities and Markets Authority), the agency responsible for enforcing it, is a new legislative framework that will "strengthen investor protection and improve the functioning of financial markets, making them more efficient, resilient and transparent."

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In Brussels jargon, a piece of EU legislation is called a "Directive." MiFID II has a buddy called MiFIR, the "Markets in Financial Instruments Regulation," which - you guessed it - is the set of detailed rules and regulations that implement MiFID II.

I mentioned that MiFID II / MiFIR comprises about 1.4 million paragraphs of regulations. What this means, of course, is that probably no single human being anywhere on the planet understands, or has even read, the totality of MiFIR.

MiFIR is a huge book of rules with different sections that apply to different financial instruments. A bond trader will read (one hopes) the bit relevant to bond trading; a forex trader will read the bit relevant to forex trading; and so on.

Technology changes, so times change

This may change a few years hence, once an advanced machine intelligence specialized in financial markets, equipped with a gigantic memory and amazing pattern recognition capabilities, has been developed by some hedge fund, or perhaps by Google Alphabet subsidiary DeepMind. Such an intelligence will be able to read, remember and interpret vastly more text and financial data than any human.

Computers engaged in algorithmic trading already account for the bulk of trading on exchanges. Soon, artificially intelligent systems (AIs) will take over more and more financial market functions, including portfolio decisions. They'll have a far better systemic overview, with instant access to comprehensive data flows, far bigger bandwidth and speed, and so on. Humans will no more be able to compete with AIs in the game of placing financial bets on markets than rats are able to compete with humans at solving crossword puzzles.

For now, though, we still have overpaid people playing the financial trading game in towers in London, Frankfurt, New York and elsewhere.

Now let's look at a couple of the key components of MiFID II / MiFIR, before we get back to watching cute kitty videos on the interwebs, like normal people.

Shining a brighter light on trades

Apparently a basic goal of MiFID II is to drive financial markets toward a reduction in fraud and incompetence, mostly through requiring more transparency on trades and research.

One key measure is to push virtually all trading, regardless of financial instrument, onto regulated, monitored electronic exchanges, and away from the old practice of brokers taking or placing orders on telephones ("over-the-counter" trading).

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According to the Financial Times, this will generate better audit and surveillance trails and "a wave of data, likely to be measured in petabytes... Trades will be timestamped, to 100 microseconds for some, while information in documents for transaction reporting will stretch to more than 65 fields" in electronic forms. The data will have to be stored for a minimum of five years.

Banks and brokers will be required to show customers documentary evidence that they were offered the best available price for their trades.

These measures should make financial markets more efficient, in the sense of allowing investors to more easily find the best competitively determined price. It should also make it harder to commit fraud.

Paying for financial products research

Another novelty embedded in the new rules is a change in how financial portfolio managers pay for advice and information, or "research," on financial instruments they might want to consider buying.

Before now, a portfolio manager working for a big financial company — let's call it BigFin — would generally get their "research" free-of-charge, in a phone call or written report, from an in-house "analyst," i.e. a colleague in BigFin's research department. The cost of doing the research was absorbed in the trading fees charged to clients.

Suppose the portfolio manager isn't managing BigFin's own money, but rather, is managing some money for a client of BigFin's, such as a pension fund or a group of retail investors who had entrusted money to BigFin. 

This generates a conflict of interest, because BigFin's analysts have often found themselves under pressure to supply "research" to portfolio managers driven less by accurate analysis of a given financial product, and more by BigFin's own financial position related to that product.

For example, let's say BigFin happened to own a billion euros' worth of regional US mortgage derivatives which had begun to turn sour as the regional housing market went into a downturn. BigFin's analysts might be quietly told by BigFin's trading desk to encourage BigFin's portfolio managers to buy precisely those derivatives on behalf of their external clients so that BigFin could offload its loss-making position onto BigFin's clients.

This wasn't a hypothetical risk. Over the past decade or so, companies like Goldman Sachs or Deutsche Bank have paid billions of dollars and euros in fines for malfeasance of this nature.

Under MiFID II, research reports and advice will be "unbundled," i.e. portfolio managers will have to pay for all research from analysts, even if it's from in-house analysts. Moreover, the new rules explicitly stipulate that "investment advice" provided to clients has to be in the client's interest. 

Not just Europe

MiFID II rules apply everywhere in the European Union. But does this have anything to do with you if you live outside Europe?

Yes, it does. If a fund manager wants to buy a financial instrument — whether stocks, bonds, derivatives, or anything else — which has any underlying products listed in the EU, it falls under MiFID, regardless of where the fund manager is based. For example, an exchange-traded fund (ETF) which includes some European-listed stocks is covered, even if the stocks are secondary listings of an American company like Apple or Alphabet.

It's possible that MiFID II may therefore force changes in regulation of financial instruments and trades in the US securities markets as well. Stay tuned.