That will soon be how European buyside firms trading certain securities over the counter will have to do business, whether they like it or not. And getting ready for the change won’t be simple, or cheap.
Under the revised Markets in Financial Instruments Directive – which kicks in on January 3, 2018 – buyside firms will have to report some OTC equity trades themselves within a minute of execution, and non-equity OTC transactions within 15. This requirement is known as post-trade reporting.
But that’s not all. Within a day of a trade they will also have to provide regulators with a more detailed account of the transaction; one that has 65 data fields including the passport number and date of birth of the person responsible for the trade. This requirement falls under the category of transaction reporting.
The cost of getting systems ready for Mifid II, including its new reporting rules, is estimated to top $ 1 billion for the buyside in 2017. This is according to a survey of 40 banks and 400 asset managers by IHS Markit and Expand, a consultancy owned by the Boston Consulting Group, published on September 29.
Sarah Hay, head of market structure and liquidity strategy at UBS in Europe, the Middle East and Africa, said: “Mifid II is introducing a quantum of change for the industry. Many of the extended transparency requirements will introduce major challenges for the buyside on a cross-asset basis, with both transaction reporting and post-trade reporting being hot topics for debate.”
The post-trade problem: Can’t I just call my broker?
It is the new requirements around the real-time post-trade reports that look set to provide the biggest challenge for the buyside. Under the first iteration of Mifid, these reports were limited to equities and had to be published to trade data monitors within three minutes of a transaction. Crucially, a buyside firm could have its broker do this and carry no legal responsibility for the task.
Mifid II is extending the scope to fixed income, derivatives and commodities trades, speeding up the process and making it so these will have to be reported through newly created approved publication arrangements, or APAs, which will mainly be operated by exchanges and other trading venues.
Furthermore, buyside firms will carry the legal responsibility for certain reports – and therefore any fines for reporting failures – even if they outsource the process to brokers or elsewhere.
The rules of reporting
The situations in which they will be legally obliged to report are: when trading away from an exchange or other trading venue; are the seller of a security; their counterpart is either a non-EU entity, or an EU entity that is not a systematic internaliser, or SI (a firm that uses money from its own account to complete client orders).
Such scenarios may only account for a small number of a firm’s trades over a year but to prepare for when they do arise, the buyside effectively has three options, according to Caleb Wright, head of market structure and execution consulting at Bank of America Merrill Lynch.
He said these were “either to build their own reporting capabilities, put in place a form of outsourced solution, or ensure the situation never arises in which they have to report”.
All have their pros and cons, but with Mifid II less than 15 months away, decisions will need to be made soon.
Option 1: Do it yourself
In order to report themselves, buyside firms will have to set up a direct connection with an APA. A handful of providers are intending to register as APAs and will be competing for buyside business. They include TRADEcho, a joint initiative between London Stock Exchange and Boat Services, the MarketAxess-owned Trax; and stock exchange operator Bats Europe. The latter will focus only on equity reporting, having recently shelved plans to offer a multi-asset class APA, according to its COO Dave Howson.
Jamie Khurshid, CEO of trade reporting provider Boat Services, said many in the market would rather bring reporting “in-house and centralise it through a direct relationship with an APA”.
This has the major benefit of being able to satisfy any reporting obligation should it arise, and not involve setting up outsourced agreements with potentially hundreds of brokers.
However, this is a two-way deal and buyside firms will need to develop new trading infrastructure to ensure they have the data required by APAs in real-time. Geoffroy Vander Linden, the head of transparency solutions at Trax, said: “The buyside need a considerable amount of information to report to APAs properly, and the infrastructure they need to receive that information in real-time needs to be expanded or developed.”
Option 2: Outsource
Given the potential cost and time of upgrading their tech, many buyside firms may simply think it better to ask their broker to take care of things. However – while this would ease the IT burden – choosing this option raises a question about whether the buyside should have to pay for that service separately, given it might be deemed a trading inducement.
Hay at UBS said: “There’s definitely been that debate in the industry. I’d say there are larger discussions around potential inducements in other areas, but it is a consideration that has been discussed if the service is not paid for.”
Another issue surrounds the number of brokers a dealing desk uses and the potential of having to set up multiple outsourcing agreements. Khurshid said: “The feedback we are getting from bigger buyside firms is that because they use so many brokers they do not want to have to outsource reporting with each of them individually.”
And, of course, there’s the risk that a reporting failure on the part of the broker could end up biting the buyside firm with the ultimate legal responsibility under Mifid II.
Option 3: Using SIs or EU-only counterparties to dodge the bullet
It is possible that a buyside dealer decides to use a trading counterparty, such as an EU broker that runs a systematic internaliser, purely to avoid the reporting obligation. This carries the obvious downside of potentially missing out on valuable liquidity, particularly from non-EU firms, according to Matt Coupe, a director for market structure at Barclays. He said: “There are many instruments – such as Japanese interest rate swaps – that are traded heavily in Europe.”
Furthermore, Coupe said that selecting counterparties in this way could breach of Mifid II’s best execution rules, which require firms to get the best prices for their end clients.
In any case, it may not be that easy to find a counterparty to complete the trade as there may be many instruments for which no broker registers as an SI.
The SI construct is already established in equities. Firms including UBS, KCG and Credit Suisse already operate SIs and plan to continue doing so under Mifid II. The SI construct is designed to capture bilateral trades between brokers and their clients that involve the use of a broker’s own capital. Any broker registered as an SI in a particular instrument is required to post firm quotes that clients can hit for orders up to a certain size.
Under Mifid II, the concept is being extended to other other asset classes and being an SI will be obligatory if a firm meets certain trading thresholds. The problem for brokers is that it is far more difficult fo make a call about whether they well set up as an SI in non-equity asset classes. That is because there is less robust market data for brokers to gauge whether or not they meet the SI thresholds, and the multitude of products could make the requirement to post firm quotes as an SI potentially onerous. That uncertainty is having a knock-on effect on buyside decisions on reporting.
Vander Linden said: “There was a feeling that the buyside could just trade with SIs to avoid the reporting obligation but now that thinking has changed. While they may be able to trade with SIs in equities across all instruments, that is unrealistic in fixed income.”