Mentioning the MiFID elephant

The Markets in Financial Instruments Directive (MiFID) is the elephant in the asset management room but it is not one that people are failing to mention. They just don't quite know what kind of a beast it is.

MiFID will introduce a single market and regulatory regime for investment services across the 30 member states of the European Economic Area (the 27 EU members plus Iceland, Norway and Liechtenstein). It has three objectives: first, to complete the process of creating a single EU market for investment services, second, to respond to changes and innovations which have occurred in securities markets and third, to protect investors by making markets deeper, more competitive and more robust against fraud and abuse. It will replace the Investment Services Directive (Directive 93/22/EEC).

Introduced in 1999, MiFID is the cornerstone of the European Commission's Financial Services Action Plan whose 42 measures will significantly change how EU financial service markets operate.

For a long time, asset managers thought that it would only affect the sell side, so they didn't need to worry about it. But it has become clear that this is not the case. Although MiFID will largely affect banks, prime brokers and exchanges, it does impinge on some aspects of investment management.

There are three ways in which MiFID is applicable to asset managers: client categorisation, transaction cost analysis and best execution.

The first requires firms to categorise clients as ‘eligible counterparties', professional clients or retail clients, with increasing levels of protection for each. Firms operating in the UK have already gone through most of this process as regulation from the Financial Services Authority (FSA) preceded the European Commission's directive. All they have to do now is a quick check of their procedures to make sure that they are consistent with the requirements of MiFID. Outside the UK, new procedures may have to be set in place.

The requirement under MiFID for best execution brings with it a need for efficient transaction cost analysis, both pre- and post-trade. According to a recent survey of asset managers (mostly traditional, but including some hedge funds) by French research group Edhec Risk Advisory, only half of respondents, which did not encompass the entire sample, use pre-trade analytics.

"It is striking to see that pre-trade analytics may not have yet reached the desk of the majority of buy-side firms," Edhec commented in its report.

Post-trade analytics requires significant investment in technology in order to provide comparable figures; Edhec paints a gloomy picture of the industry's readiness to provide this.

A plethora of reports and surveys by consultancies and IT providers has been similarly downbeat, but one stands out as being much more positive. Investit, an investment management consultancy, ran a seminar for its clients last November, during which it found that although it is difficult to estimate how much MiFID implementation is likely to cost, this is not because firms are ignoring it. Of the nine investment management firms that attended Investit's seminar, just one had a separate MiFID budget. The others were finding that they could incorporate the changes into existing business projects, so that the only dedicated resource they needed was a single programme manager.

"Given the number of MiFID scare stories we've read, it's good news to hear that investment management companies are able to incorporate MiFID into existing ‘business as usual' projects," commented Investit's Clare Vincent-Silk. "It's apparent that MiFID projects are a lot less complicated than first feared."

Asset managers may feel they have the implementation of MiFID under control, but if they outsource any of their operations, they will have to check that their service provider has identified which of their services, and therefore the legal entities delivering such services, do fall within MiFID's scope.

The complications may not be as great as some IT infrastructure providers would have one believe but there is a significant issue in the disparate rate at which the different countries are implementing the directive.

Even after the deadline was postponed for a year, the 30 countries affected will struggle to meet it. The FSA's website states that by 31 January 2007, "all national authorities need to have made the necessary changes to law and rules - the transposition date". Just two countries, the UK and Romania, met the deadline; Ireland has since caught up, leaving 27 countries trailing.

This poses a significant challenge for companies trying to offer services across more than one European market.

"There is only uncertainty at the moment," says Graziella Marras, senior policy adviser at EFAMA, the European Fund and Asset Managers' Association. She points out that this failure to meet the transposition deadline means the industry will have no time to assess the requirements of MiFID legislation on a pan-European basis. Companies are supposed to be compliant by November 2007, but several countries have already signalled that they will not meet this deadline.

"In order for it to work, everyone has to have adopted it at the same time," says Helen Stephenson of the UK's Investment Managers' Association. The UK's robust regulatory situation may give companies operating there an advantage, but it won't solve the problem of how to be MiFID compliant across a set of jurisdictions that cannot yet offer guidance as to how and when they will implement the legislation.

"I would say the only people who can be upbeat about this are lawyers and consultants," says Marras. "MiFID will be a huge problem in terms of implementation."

EFAMA has also raised the concern that there is so much overlap between MiFID and the product regulation directive for mutual funds, UCITS. Questions about whether distribution of UCITS funds falls within the scope of MiFID and how inducements should be regulated are up for discussion.

"There has been a lot of discussion at the level of the Committee of European Securities Regulators (CESR) regarding inducements," says Marras. She adds that best execution in the distribution of fund units might also potentially be within scope.

Some industry commentators predict that the requirement for all links in the value chain to offer transparency as to how much they are costing the end investor and what value they offer in exchange for that cost has the potential to change the retail funds market dramatically. It is less clear that it will have significant impact on the institutional market, where most investors would hopefully feel they are already aware of what they are paying and what they are getting for it.

CESR is doing its best to chivvy its members to a state of consensus and action in time for the deadline, but it faces the perennial challenge of such pan-European bodies: how to balance the need for general rules that apply across the continent with the members' reluctance to give up micro-control within their own jurisdictions.

In its response to the CESR consultation on the passport under MiFID, the IMA pointed out that "the purpose of harmonising directives such as MiFID is to open up the EU single market by removing barriers and burdens on cross border activities." This should be of benefit to all, not just the lawyers and consultants, but whether the asset management industry will be a beneficiary or simply carry the burden of confusing regulation is not yet clear.