Investing in the future: securities trading in a single capital market

Date: 05/12/02

Mattias Levin takes a look at the Commission's proposal for a new Investment Services Directive - the linchpin of the EU's financial services action plan

AS THE EU builds up a body of legislation to achieve a single capital market, the time has now come to tackle securities trading.

Amid alarming headlines, in the British financial press in particular, on 19 November the European Commission formally adopted a draft proposal for a new Investment Services Directive (ISD).

The discontent from some traders is an illustration of how important the ISD is - and how contentious the review has become.

The ISD matters because it regulates traders and where execution dealing takes place in the EU, hence shaping market structure. It is contentious, as regulatory choices on market structure can determine who trades profitably.

As one of the cornerstones of the EU's financial market legislation, the ISD lends itself badly to summarising in a few lines.

The aim of the new proposal is to achieve a directive that better protects investors and integrity, while promoting efficient and integrated markets.

Overall, faced with an increasingly complex and diversified trading landscape, the Commission has chosen a fairly light-touch approach. Generally, the proposal retains the division between regulated markets and investment firms.

It contains stronger rules regarding the operation of investment firms (eg conflicts of interest) and their relationship with clients (eg best execution).

For regulated markets, the proposal provides for more harmonised rules relating to organisational requirements, the operators of the market, admission of instruments to trading and transparency.

The ISD also contains elaborate provisions on supervisory authorities, in particular concerning the designation in each member state of a competent authority and its powers and resources.

In spite of this wide scope, the key proposals that have caused much lobbying, and are likely to be the battleground for debate in the European Parliament and the committee of European securities' regulators (CESR), relate to competition between trading venues.

While such competition is largely beneficial, it may be harmful if it leads to fragmented liquidity. Such fragmentation results in less informative prices and, consequently, investors risk not getting the best deal when they trade.

Regulators can reduce this risk by requiring trading houses to publish price information before and after a trade is done. However, if they are not well-designed, such requirements are potentially burdensome and may increase the cost of trading.

After more than a year of consultation, the Commission's proposal contains new transparency requirements for regulated markets and investment firms, the latter including alternative trading systems (or multilateral trading facilities - MTFs in the Commission's terms) and broker-dealers.

For regulated markets, a comprehensive transparency regime will continue to apply.

As for pre-trade information, regulated markets will have to make public part of their order book if they are order-driven while quote-driven markets' traders will have to publish some of their bid- and ask-quotes.

As regards after-trade transparency, regulated markets will have to publish prices, volumes and times of all equity trades (the only exception being for larger block trades).

Critically, the proposal contains no concentration rule. Instead of routing all trade orders to a regulated market, which the current ISD allows member states to require, broker-dealers will be free to settle orders elsewhere provided that their clients allow them to.

If executed on alternative trading sytems and/or MTFs, roughly the same transparency rules will be in place as if executed on a regulated market.

Today, however, larger broker-dealers also operate their own trading desks.

As a result, they can settle orders from clients in their own books, a process known as 'internalisation'. While internal order execution makes the trade execution services sector more contestable, it offers some investors better net prices and provides some traders with services they cannot get elsewhere.

Internalisation nevertheless comes with certain risks. First, it will draw away orders from exchanges' central books.

As a result, prices quoted on these exchanges will become less informative, especially if many orders are internalised.

Second, it may weaken central markets by reducing the incentive competing brokers have to price aggressively, as such aggressive practices would not receive any additional orders if other brokers executed their clients' orders in-house.

Third, broker-dealers may face a conflict of interest. It is obviously beneficial for them to execute orders in-house, as this enables them, for example, to time the execution of their retail clients' orders to fit their own trading interests or those of a larger, favoured customer.

This is not necessarily in the interest of their retail clients.

While acknowledging these risks, broker-dealers - primarily in the City of London - have claimed that internalisation is a supplementary trading method satisfying the needs of a fairly limited number of investors and, as such, is unlikely to capture a large share of order execution.

This type of investor prefers internalisation because it provides best execution in a broader sense, where price is only one of many parameters including also anonymity and flexibility.

The requirement to disclose quotes and orders would, it is claimed, all but remove the possibility of broker-dealers offering such services.

Instead, the argument goes, separate rules on conflict of interest and best execution would limit the potential risks of internalisation while preserving its advantages.

Faced with this trade-off, the Commission has opted for a compromise. It has taken the position that, all in all, transparency of orders and quotes is the most sensible way to ensure best execution and investor protection.

However, the Commission acknowledges that the same transparency rules cannot apply to off-exchange order execution as to orders executed on a regulated market. It therefore proposes two requirements for brokers internalising orders:

Client limit-order display rule (Article 20:4): this will require investment firms to publish those limit orders (instructions to trade at best price, but not worse than specified limit) that they are unwilling or unable to execute themselves immediately.

Such unexecuted limit orders are interesting from a price point of view and the rule's aim is to ensure that that information reaches the market.

It allows a number of exceptions, however. If clients request orders not to be disclosed, investment firms will not be obliged to publish. Also, the rule does allow exceptions for large transactions.

Quote disclosure rule (Article 25): the Commission also proposes to require investment firms that run a trading book to publish the terms (bid- and ask-quotes) at which they are ready to trade typical retail transactions in liquid equities.

This would increase the information available to other market participants. Also, it would expand the number of trading venues that are taken into account when assessing best execution prices.

By limiting the rule to retail trades and liquid equities, the Commission has tried to ensure that the rule will not impede larger transactions.

Whether or not brokers should supply pre-trade information may seem an arcane and irrelevant issue. However, the lobbying illustrates the critical link between regulation and market structure.

While the debate is primarily driven by regulatory concerns, the lobbying surrounding that debate should be read in the light of competition between trading venues wanting to shape rules so that their potential to capture orders is maximised.

The focus on transparency requirements is understandable, but may turn out to be unfortunate, however.

The scope of the ISD is wide and there are many other areas that merit further debate (eg whether the conflict of interest rules were sufficiently strong or the feasibility of rules regarding best execution).

It remains to be seen whether the debate in the Parliament will cover such issues or whether it will once again become a contest between competing trading venues for the lawmakers' attention.

• Mattias Levin is a research fellow at the Centre for European Policy Studies (CEPS).

Feature looks at the Commission's proposal for a new Investment Services Directive - the linchpin of the EU's financial services action plan. The author is a research fellow at the Centre for European Policy Studies (CEPS).

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