MiFID II is one of the most pivotal pieces of legislation enacted in finance and investing this century. Rolled out in 2018 by the European Union (EU) to regulate financial markets while increasing protections for investors, its aim was to standardize financial practices across the EU and restore confidence in the industry, especially after the 2008 financial crisis.
Key Takeaways
- MiFID II, a European Union (EU) packet of financial industry reform legislation, came into effect in 2018.
- MiFID II covers virtually every asset and profession within the EU financial services industry.
- MiFID II regulates off-exchange and over-the-counter trading, essentially pushing it onto official exchanges.
- Increasing transparency for trading costs and improving record keeping for transactions are among the key aims of the regulations.
Understanding MiFID II
MiFID II amends the original Markets In Financial Instruments Directive (MiFID) from a decade before. It rolled out on Jan. 3, 2018, six years after the European Commission, the EU’s executive branch, adopted the legislative proposal. MiFID II set out goals for greater transparency in the member states, and the concurrently enacted Markets in Financial Instruments Regulation enacts rules for financial institutions within the EU. Colloquially, MiFID II refers to both, and we’ll use the term to cover both EU enactments in what follows.
The original MiFID went into effect in November 2007. The global financial crisis exposed its weaknesses soon after, revealing that it focused too narrowly on stocks, ignoring fixed-income vehicles, derivatives, currencies, and other assets. MiFID also did not address dealings with firms and investment products from outside the EU, leaving rules about those to the discretion of EU member nations.
MiFID II standardizes oversight of the financial industry among member nations and greatly broadens the scope of the EU’s regulation of securities markets. In particular, it imposes more reporting requirements and tests to increase transparency and reduce the use of dark pools and over-the-counter (OTC) trading.
The regulations extend MiFID’s earlier requirements to more financial instruments. Equities, commodities, debt instruments, futures and options, exchange-traded funds, and currencies all fall within its range. If a financial product is available in the EU, it is covered by MiFID II—even if, say, the trader wishing to buy it is located outside the EU.
$2.1 Billion
That’s the cost EU companies spent preparing for MiFID II, according to the Boston Consulting Group, as reported by the Wall Street Journal.
MiFID II captures virtually all aspects of financial investment and trading and all professionals operating in the EU. Bankers, traders, fund managers, exchange officials, and brokers and their firms all have to abide by these regulations, just as institutional and retail investors must.
MiFID and MiFID II: Key Differences
MiFID
- Applied largely to equities markets
- 73 articles
- Drafted in 2004 and came into effect in 2007
- Did not address dealings with firms or products outside the EU
MiFID II
- Applies to all types of securities and derivatives
- 97+ articles
- Proposed in 2012 and effective from 2018
- Applies to any firms wanting to access and trade in EU products, regardless of their location
Key Regulations of MiFID II
MiFID II brought sweeping changes to trading and investing. Here are some of the most critical:
Regulated Trading
A major goal of MiFID II was to move trading out of the shadows from over-the-counter (OTC) trading and dark pools to regulated trading platforms. MiFID II created a new trading venue, the organized trading facility, to capture previously unregulated trades. In addition, investment firms that want to execute client orders must be a multilateral trading facility (MTF).
MiFID II limited the trading volume of a stock in a “dark pool” to 8% of the total trading volume of that stock anywhere over 12 months. Such pools allow institutional investors to trade large blocks of securities without details being public until later. MiFID II aims to balance the need for privacy in large transactions and the public’s need for transparency and information.
Transparency
Transparency was another major goal of the legislation. For starters, regulated markets and MTFs are required to publish the bid and offer prices of securities continuously. But the legislation goes much further.
Banks and brokerages can no longer charge for research and transactions in a single bundle, making it clearer to clients what each costs and improving the quality of research available to institutional and retail investors alike.
- Transparency in costs: MiFID II ensures greater transparency by separating the charges for research and transactions. Investors can now see exactly what they are paying for each service, providing them better information when deciding which services to pay for.
- Quality of research: The separation of charges for research and transactions could lead to better quality in financial research delivered to investors, as researchers have an incentive to produce higher-quality work to justify their expense to clients.
- Fair competition and investor protection: This separation promotes fair competition among service providers and prevents overcharging, also protecting investors from unknowingly subsidizing research costs through transaction fees.
Investor Protection
MiFID II restricts the inducements paid to investment firms or financial advisors by third parties for indirect access to their clients. This reduces major conflicts of interest when banks and investor services offer advice and services.
Without such regulations, there’s a risk that financial advisors might recommend products or services not because they are the best options for their clients but because they offer the most lucrative commissions or other benefits to the advisors.
Investment firms are required to take “all sufficient steps” to obtain the best possible results for their clients and to act in their best interest, which includes transparency about commissions and fees.
Reporting Requirements
Investment firms must give regulators reports detailing each transaction they execute by the following day and keep records of all communications, including phone conversations. This enables regulators to monitor potential market abuses better.
Transaction reporting is not just required for sell-side firms but also for the counterparties who initiate the trade.
Commodity Speculation and High-Frequency Trading
MiFID II places far greater scrutiny on algorithmic trading and high-frequency trading (HFT) to improve transparency, prevent manipulation or abuse, and ensure fair trading practices. Firms had to adjust their trading strategies, invest in compliance and infrastructure, and maintain detailed records of trading activities and algorithms.
- Transparency: MiFID II requires detailed reporting on trading data, including the algorithms and strategies used in HFT. This allowed regulators to monitor manipulative or abusive strategies.
- Testing Algorithms: Trading venues and investment firms must have resilient algorithms. The firms must keep records of their testing procedures and results to ensure compliance with the regulations.
- Market-Making Rules: The rules place strict guidelines on firms using algorithmic trading for market-making strategies, ensuring continuous liquidity even in high volatility periods.
- Tick Size Regime: MiFID II introduced a standard tick size across the EU, affecting HFT strategies that rely on small price differences.
- Anti-Fraud Measures: MiFID II enacted rules against practices like quote stuffing to maintain a fair trading environment.
What’s Next For Financial Regulations After MiFID II?
The law mandated a review that began in 2020 of its effects on the EU’s financial markets. In October 2023, the EU finalized changes highlighted in the review to put to a parliamentary vote, aiming to increase transparency and ban conflicts of interest.
Consolidated Data Feeds Across the Bloc
The EU would establish centralized data feeds, or consolidated tapes, to aggregate crucial market data from multiple trading platforms. This aims to give institutional and retail investors easier access to the latest data on trading volume and prices.
No More Payments for Order Flow (PFOF)
A proposed ban would prevent brokers from being compensated for directing client orders to specific trading platforms. Some member states have a grace period until 2026 to enforce the ban, aligning with U.K. policies.
Emergency Measures in Place
The EU’s regulated markets will need plans to temporarily pause or limit trading during emergencies or significant price fluctuations over a short period. In extraordinary circumstances, markets should be able to cancel or change transactions as needed.
What Is a Dark Pool?
Dark pools are private asset exchanges providing additional liquidity and anonymity for trading large blocks of securities away from the public eye. They offer cost advantages to mutual funds and pension funds. However, their lack of transparency makes them susceptible to conflicts of interest and predatory trading practices by high-frequency traders.
What Is the US Equivalent of MiFID?
According to the World Bank, the federal rules most comparable to MiFID are:
- 1934 Securities Exchange Act: This act established the Securities and Exchange Commission (SEC) and granted it authority over the securities industry, including brokerage firms and exchanges.
- 1998 Regulation Alternative Trading System: It required alternative trading systems to register with the SEC and adhere to specific regulations.
- 2005 Regulation National Market System: Designed to modernize and strengthen the U.S. equity trading system with rules promoting fair access to market data and increasing transparency.
How Did Brexit Change MiFID II in the UK?
Post-Brexit, the U.K. adopted much of MiFID II into its law to provide continuity and stability. However, the U.K. has aimed for “sustainable” deregulation through the Edinburgh reforms and other proposals, seeking to remove remaining EU rules while preventing post-2008 regression.
The Bottom Line
MiFID II revolutionized how investors in the EU buy, sell, and trade financial securities. It introduced greater transaction transparency, reduced OTC and dark pool trading, and ended legal conflicts of interest that potentially prioritized investment managers’ interests over clients’. Additionally, it demanded more scrutiny in high-frequency trading, aligning them with requirements for transparency and fairness.
Related Terms: Markets In Financial Instruments Directive, financial transparency, dark pools, high-frequency trading.
References
- European Securities and Market Authority. “MiFID II”.
- The Wall Street Journal. “What Investors Need to Know About Europe’s Big New Mifid Rules”.
- European Securities and Market Authority. “MiFID II Transparency Calculations and DVC”.
- Giulio Anselmi and Giovanni Petrella. “Regulation and Stock Market Quality: The Impact of MiFID II Provision on Research Unbundling.” *International Review of Financial Analysis.*Vol. 76 (2021).
- European Securities and Market Authority. “Article 27 Obligation to Execute Orders on Terms Most Favourable to the Client”.
- The World Bank. “Comparing European and U.S. Securities Regulations MiFID versus Corresponding U.S. Regulations”, Page 6.
- G. Giusti and K. Batbayar. “UK Post-Brexit Financial Regulation: The Status Quo on Equivalence.” ERA Forum. 21/2 (2020). Pages 199–207.
- Financial Conduct Authority. “Handbook on MiFID II”.
- Reuters. “Britain Reviews Financial Rules To Bolster City’s Global Clout”.
- Government of United Kingdom. “The Edinburgh Reforms”.
- Reuters. “Britain to Ease EU Rule on Charging Asset Managers for Stock Picks”.
