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The price of stable markets and investor confidence: some thoughts on MiFID II’s cost-benefit ratio

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This Article analyses certain aspects and controversial matters of the revised Markets in Financial Instruments Directive (MiFID II) in view of the reform’s potential to improve investor confidence and market stability.

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Notes

  1. ‘An Act to provide for the safer and more effective use of the assets of banks, to regulate interbank control, to prevent the undue diversion of funds into speculative operations, and for other purposes’. It is often mentioned when referring to the separation of commercial and investment banking in Sects. 16, 20, 21, and 32.

  2. Galbraith [9], p. 13.

  3. Over-the-counter (OTC) refers to a security traded outside a formal exchange and includes also to debt securities and other financial instruments, such as derivatives, which are traded through a dealer network.

  4. Regulation (EU) No 600/2014 of the European Parliament and of the Council of 15 May 2014 on markets in financial instruments and amending Regulation (EU) No 648/2012 [2014] OJ L 173/84.

  5. ‘Democratic’ means here that investors can freely choose how to allocate their capital without disadvantage or discrimination and that the free choice is fully reflected in share prices and leads to a fair allocation of welfare.

  6. See Financial Times of 27 January 2017.

  7. The one-off cost impacts on the introduction of MiFID II were estimated to be about 0.6% (retail and savings banks) and 0.7% (investment banks) of total operating spending. Recurring compliance costs were estimated at about 0.1% (retail and savings banks) to about 0.2% (investment banks) of total operating expenditure, see European Commission, Markets in Financial Instruments Directive (MiFID II): Frequently Asked Questions (April 2014).

  8. HFT is a subset of algorithmic trading which is defined as the use of computer algorithms deciding on the timing, price, and order quantity, see Article 4(1)(39) and (40) of MiFID II. In essence, HFT is a highly concentrated form of trading, done in small fractions of seconds where computer constantly submit bids to buy and offers to sell securities. The goal of HFT is to make a profit by immediately reselling a security for slightly more than what it was bought for.

  9. HFT refers to several schemes and can be roughly classified into market making activities and more aggressive HFT strategies (e.g. statistical arbitrage).

  10. See Deutsche Bundesbank [6], p. 1, referring to the difficulties to provide a precise quantification, and Gomber/Arndt/Lutat/Uhle [10], p. 72, 73.

  11. European Securities and Markets Authority (ESMA) [8].

  12. ‘Act to avoid dangers and misuse in high-frequency trading (High-Frequency Trading Act)’ of 7 May 2013.

  13. The most prominent critique is probably Michael Lewis’ 2014 non-fiction book ‘Flash Boys: A Wall Street Revolt’, which describes HFT as a means to front-run orders placed by ordinary investors (‘greed meets speed’).

  14. Volatility is a measure of price variation of an instrument. It reflects the uncertainty about the future price of an asset or the market as a whole. It is amplified by the breadth of possible outcomes.

  15. A ‘spread’ is the difference between the bid and the ask price of a security or asset.

  16. Lafarguette [13], p. 28.

  17. See Levine [14].

  18. Autorité des Marchés Financiers (AMF) [2], p. 11, 19 et seq.

  19. ‘Stop-loss orders’ are designed to limit an investor’s loss on a position in a security. They are placed with a broker to sell a security when it reaches a certain price.

  20. A ‘bear market’ describes a downturn of around 20% or more from a peak in multiple broad market indexes, such as the German DAX (Deutscher Aktienindex) or Standard & Poor’s 500 Index (S&P 500), over a two-month period which is due to investor pessimism.

  21. See Zhang [21], p. 8.

  22. See Hendershott/Jones/Menkveld [12], p. 10–11.

  23. See Lafarguette [13], p. 22.

  24. On 4 December 2015, the Autorité des Marchés Financiers (AMF) sentenced HFT firm Virtu Financial Europe and French market operator Euronext Paris to the highest fines ever imposed in a HFT related case of market manipulation of €5 million fine on each company.

  25. ‘Layering’ describes carrying out complex financial transactions to camouflage the illegal source of cash for money laundering purposes.

  26. ‘Quote Stuffing’ describes the tactic of quickly entering and withdrawing large orders in an attempt to flood the market with quotes that competitors have to process, thus causing them to lose their competitive edge in high frequency trading.

  27. Market maker Knight Capital lost $440 million in 30 minutes because an errant algorithm made millions of trades in 150 stocks, buying at higher ask price and instantly selling them at lower bid price, on Bloomberg.com (August 2012).

  28. Art. 17(3) MiFID II.

  29. The London Stock Exchange, for example, created TRADEcho, a single, multi-asset, pan-European reporting solution which is promoted as ‘facilitating efficient pre- and post-trade reporting in an increasingly complex regulatory landscape’.

  30. Art. 7 MiFIR.

  31. Bernales/Riarte/Sagade/Valenzuela/Westheide [3]; Degryse/de Jong/van Kervel [5], pp. 1587–1622.

  32. Petrescu/Wedow [16], p. 52.

  33. Liquidity detectors gathering information about algorithmic traders are also frequently referred to as ‘sniffing out’ other algorithms or ‘snipe’ in order books or dark pools to retrieve information from them, see Gomber/Arndt/Lutat/Uhle [10], p. 28.

  34. Lafarguette [13], p. 26.

  35. Degryse/de Jong/van Kervel [5].

  36. Gresse [11], p. 34.

  37. Each dark pool may only handle 4% of overall trading in individual security, while total dark trading is restricted to 8% of overall volume in each stock (negotiated trade waiver). MiFID II and MiFIR also impose restrictions on the share of trading for equity and equity-like instruments that occur under the reference price and negotiated transaction waivers. Exceeding caps leads to a ban on trading the stock on any dark pool for six months. The ‘large in scale waiver’ however still applies.

  38. According to Art. 28(2) MiFID II, Member States shall provide that the competent authorities may waive the obligation to make public a limit order that is large in scale compared with normal market size as determined under Art. 4 MiFIR.

  39. Petrescu/Wedow [16], p. 18.

  40. Angel [1], p. 1 et seq.

  41. Art. 49 MiFID II.

  42. This which appears even more problematic where the minimum tick size is not communicated to all concerned traders: The U.S. Securities and Exchange Commission (SEC) charged a UBS subsidiary with disclosure violations at operating a dark pool for having failed to properly disclose to all subscribers the existence of an order type that it pitched almost exclusively to market makers and HFT firms, enabling them to place orders priced in increments of less than one cent. The bank agreed to settle the charges by paying $14.4 million, including a $12 million penalty, which was the SEC’s largest fine against an alternative trading system.

  43. European Securities and Markets Authority (ESMA) [7], p. 281.

  44. See Angel [1], p. 10.

  45. See Art. 24(4) MiFID II and Arts. 50 and 59(4) of Commission Delegated Regulation (EU) 2017/565 supplementing MiFID II as regards organisational requirements and operating conditions for investment firms and defined terms for the purposes of that Directive.

  46. In Germany, the first case on hidden commissions decided by the Imperial Court of Justice (Reichsgericht) dates back to 1905. On 19 December 2006, the Federal Court of Justice (Bundesgerichtshof) ruled that sales organisations must inform their clients on kick-backs or pay damages in case this information is omitted or unclear (Az. XI ZR 56/05). In Austria the Supreme Court of Justice (Oberster Gerichtshof) ruled on 7 November 2007 (Az. 6 Ob 110/07f) that kick-backs that an investment fund company receives from the depositary bank for every restructuring in the portfolio, forms an inducement to trade securities as often as possible, even though this may not be in the interest of the fund investors. The court qualified such kick-backs thus as ‘endangering client interests’ and granted the investors not only the kick-back payments paid by the depositary to the fund manager but also damages for trading losses. There is however no damage claim where the client was informed about the kick-backs.

  47. Art. 24(9) MiFID II.

  48. Art. 11 of Commission Delegated Directive (EU) 2017/593 of 7 April 2016 supplementing Directive 2014/65/EU of the European Parliament and of the Council with regard to safeguarding of financial instruments and funds belonging to clients, product governance obligations and the rules applicable to the provision or reception of fees, commissions or any monetary or non-monetary benefits.

  49. Yonge/Stone/Baltz [20].

  50. Sandler/Schrader/Evans [17], p. 409 and 411. See also: Investment Management Association (IMA): The Use of Dealing Commission for the Purchase of Investment Research (February 2014).

  51. Art. 13 of Directive (EU) 2017/593.

  52. Art. 13(3) of Directive (EU) 2017/593.

  53. See Mahmud/Williams/Elliott [15]; Boyd [4].

  54. Taleb [18], p. 14.

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  2. Autorité des Marchés Financiers (AMF): Study of the Behaviour of High-Frequency Traders on Euronext Paris. Available at: http://www.amf-france.org/technique/multimedia?docId=workspace://SpacesStore/619a82db-11ea-4544-a03e-991b7af2864d_en_1.0_rendition (January 2017)

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    Martin Schulte

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Correspondence to Martin Schulte.

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For helpful comments and discussions I am grateful to Pablo Biscari García and Dr Ekkehart M. Jaskulla. The views expressed in this article are exclusively those of the author and may not be associated with the European Central Bank or its decision making bodies.

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Schulte, M. The price of stable markets and investor confidence: some thoughts on MiFID II’s cost-benefit ratio. ERA Forum 19, 19–31 (2018). https://doi.org/10.1007/s12027-018-0502-y

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