Many financial markets including the Forex and CFD (commodities for difference) markets are decentralized. This basically means that the facilitators of the services, in this case, the brokers, have complete control over their operations and records. Obviously, this leaves a lot of room for fraudulent practices by these same brokers, which is why MiFID II has been introduced into these financial sectors.
What exactly is MiFID II?
By definition, MiFID stands for Markets in Financial Instruments Directive and it encompasses legislations that govern the way financial companies work. The system was created in 2007 to cover financial companies operating within the EU. Now that the UK won’t be a part of the EU, the laws have been revised and packaged into MiFID II, and they are set to be implemented by the 3rd of January 2018.
Under the MiFID II framework, brokers no longer operate completely over the counter (OTC). MiFID will bring regulations to all brokers who deal with Forex, CFDs like futures, options, binary options, forwards, etc. and other financial instruments like stocks, bonds, and ETFs. All these instruments had been traded very widely on the OTC market, which is decentralized and far beyond the reach of financial regulators.
Sure, every broker needed to be registered by the local financial regulator, but their level of involvement was minimal, intervening only in certain circumstances like:
- Claims by clients of fraudulent practices by their broker – the regulator would review the records from both parties and determine the culprit. Examples of such cases in the past have involved claims of market manipulation and the churn and burn strategy used by account managers to charge interest without making any profits
- Bankruptcy claims by brokers – some brokers file for bankruptcy when they suffer extreme losses. An example is the Black Thursday incident on the 15th of January 2015. The Swiss National Bank (SNB) de-pegged their currency from the Euro. Several brokers including Alpari UK and FXCM filed for bankruptcy
- Licensing brokerages that deal with financial instruments. It is the role of the regulators to ensure all brokers meet the necessary requirements in terms of capital and infrastructure before granting them a license to operate
With the MiFID II in place, the reach of the regulators will be expanded even further in a number of ways:
Reporting of trades
All companies that deal with financial instruments will be required to submit the list of all the trades that have been made. This might be very tasking, so various Data Reporting Service Providers will be instituted to help with the collection of data. These will include:
- Approved Publication Arrangements (APAs)
- Consolidated Tape Provider (CTP)
- Approved Reporting Mechanisms (ARM)
These entities will be in charge of receiving the data from the brokers and then transfer the data to the financial regulators.
Centralized trading on certain derivatives
There are certain derivatives which are extremely risky. Binary options, for example, are decentralized and choked with irregularities. The worst part is that many financial regulators do not even oversee trading of binary options, leaving it solely up to the brokers. They have become so rife with fraud that even the CFTC (Commodity Futures Trading Commission) in the US issued a warning against trading binary options.
These and other unregulated financial assets will now be brought to a centralised trading venue to improve transparency.
Many brokers are offering leverages up to 1000:1, which while increasing profits can also lead to significant losses. In the US, leverage has been minimized to 50:1 by the CFTC to reduce the risk traders face. MiFID II will also introduce limits to the size of positions and leverage to protect traders from runaway losses.
Tests on EAs
Expert advisors (EAs) and automated trading can be a great resource for traders who are still not ready, but leaving your capital in the hands of a robot can be dangerous. Research has shown that many trading robots, EAs and algorithms are not profitable, yet the financial companies still offer them to their clients. MiFID II requires that all such automated systems be extensively tested to ensure they are profitable to the traders.
Publish quotes and reports
The first, published quotes, will enable traders to know the exact price of an asset and not fall prey to trades at a different price. This is an advantage to the traders because it will provide more confidence to their trades through informed decision making. Furthermore, the companies will be required to publish annual reports to show the quality of executions. These will be important to the regulators who want to weed out those companies offering low-quality services.
What will be different?
By creating a centralized location for regulation of financial instruments, there will be increased scrutiny into the operations of the brokers. This will help to:
Increased transparency in the markets through a centralized system
When the markets were decentralized and over-the-counter, this created loopholes whereby companies could dictate their own prices. This was especially rampant among dealing desk brokers who did not send trades to liquidity providers, essentially making themselves the market makers. In these situations, manipulation of market prices for financial instruments was common. With MiFID, this will no longer be possible and all companies will have to provide the same quotes to their clients.
Settling of disputes will also be very simple because the financial regulators will be able to track all transactions from a central location. It will be impossible for any broker to fabricate market prices because the entire system will be centralized. Clients will thus be more confident in depositing larger amounts of capital into their accounts without fear of fraud.
Better trade execution
When you think of an ECN broker (electronic communications network), processing of trades usually ended in slippage due to different quotes. The trader would request a trade and send it to the broker, who would then send the request to the liquidity provider. By the time the request reached the liquidity provider, it is possible that the price of the asset will have changed, leading to the rejection of the request. Alternatively, the request would be filled at a different price from the one the trader was expecting, and sometimes this would be inconvenient.
The centralized system of MiFID will also rectify such problems because all quotes will be provided from a central point, ensuring every trade is executed at the desired price. Furthermore, it will increase the speed at which trades are executed due to the same centralized nature of the system.
Easy access to market data
If you were a trader and wanted to know how a certain asset, say, a currency was going, it would have cost you plenty. Such information is only privy to the brokerage companies and major investment banks or hedge funds. Without this information, traders had to rely on data from the futures exchanges, but no longer. MiFID II will allow all traders to analyse the direction of a currency from the published quotes and make better decisions.
This will not only help the traders make more informed decisions, but will regulate trading behaviour in the markets. At the moment, trading charts are chaotic and unpredictable because there is no source of accurate data. There will be starting next year, and you’re going to see orderly trading behaviour in the markets. This will help companies making use of Forex market data make more informed decisions and minimize risk.
What will be the impact of MiFID?
The MiFID system will only apply in the UK, but its effect will still be felt outside the region. The most affected companies will, of course, be those operating in the UK because they will have to comply with the new regulations stated above.
As for institutions outside the UK, they will also have to abide by the regulations if they are going to be dealing with clients from the UK.
Besides the brokers, the MiFID platform will also apply to hedge funds, asset managers, trading venues and even global companies with subsidiaries in the UK.
What it means for the brokers
The MiFID II regulation will seem to be more beneficial to the traders rather than the brokers themselves. Therefore, you should not be surprised if several financial companies in the UK pack and leave the reach of MiFID II.
For those who decide to stay, they will have to start preparing early to meet all the requirements of MiFID II. With less than a year left to implement the new system, brokers should have already considered whether they are prepared to meet all the requirements. This will probably involve a restructuring of the firm’s operation to enable the dissemination of data to the regulators.
On the other hand, it won’t all be bad news to the brokers because inasmuch as the new regulations are focused on the traders, there are some benefits to the brokers themselves. Honest brokerage companies have suffered from substandard services offered by unscrupulous brokers, but this will not be the same in 2018. The truly great brokers will stand out for their excellent services and there will no longer be competition from brokers who lower quality.