The European Commission’s Markets in Financial Instruments Directive is due for final implementation from November. Many participants in the foreign exchange market still seem to be labouring under the misapprehension that Mifid will not have any impact on them, because the EU’s prime intention is to protect retail equity investors. Furthermore, the FX market is relatively confident that it is already delivering excellent execution (see Does FX need best-execution regulations? Euromoney May 2006).
Phil Weisberg, chief executive of Fxall, wrote in a recent booklet entitled Best practice in foreign exchange markets that he saw "Mifid as one of the key challenges and indeed opportunities that is front of mind for the industry. For many participants there remains uncertainty over precise details of the directive’s implementation while others see an opportunity for a more level playing field. Best execution has been on our industry’s agenda for some time and in many ways Mifid is helping to apply consistency and clarity for our clients."
Laetitia Visconti, a business analyst and Mifid expert at independent software vendor GL Trade in Paris, feels that there is no doubt that some FX players will be caught unprepared when Mifid is implemented. "FX as an instrument is not generally covered by Mifid, unless it is part of a securities transaction. However, currency derivatives, which obviously include options, fall under its scope," she says.
Visconti’s view on which FX products are covered is supported by a statement from UK regulator the Financial Services Authority. "Options and contracts for difference (CFDs) are covered under Mifid. Our view is that forward contracts are caught if entered into for investment purposes but not commercial purposes," says an FSA spokesman. "There are a number of tests under the Regulated Activities Order which are used to determine whether a contract is an investment or commercial contract, the generally accepted position is that currency forwards in the wholesale interbank market are commercial contracts."
This means that institutions will have to adapt their execution policies for options and non-deliverable forwards, and occasionally spot and outrights if they are part of a securities-related transaction, to each of the three client classifications outlined by Mifid. These are: retail, professional clients and eligible counterparties, such as hedge funds and other highly sophisticated participants that require virtually no protection.
Screen grab
Few institutions are willing to describe what they have done to ensure that they will comply with Mifid. But talking to an admittedly small sell-side sample, it seems that there is a belief that because of the classification of their clients, the banks will not have that much to do. And if they do have to prove best execution, they reckon a simple screen grab will suffice.
Visconti says: "Some market participants think that simply doing a screen grab at the time of a trade will be sufficient, and they also seem to believe that all of their counterparties will be classed as eligible, which lessens the burden. That is far too simplistic an approach. Looking at the classification of clients, some of them may decide they don’t want to be classed as eligible," she says.
While this sounds drastic, there is evidence from the equity arena that Mifid compliance might not be overly burdensome, because much of the required IT infrastructure is already in place. It just needs tweaking. As a result, many dismiss the difficulties of implementing Mifid as overstated in the same way that the issues around the Y2K issue proved to be.
Visconti believes that the approach taken by system providers in equities can be relatively easily adapted for FX. "For us, the type of market is not an issue," she says. "We can use what we’ve done in equities as a template. For instance, we have aggregated data in the US equity option markets from multiple sources and we have added functionality to our systems to allow the sell side to allocate specific client classifications to any orders they transact.
"Mifid is not initially targeting FX options. The first targets are equities and fixed income and the idea is really to protect retail investors. Later, it’s almost inevitable that it will extend more fully to other assets."
But as Mifid begins to have an impact on the options market, there is a chance that compliance will force through a fundamental change in the way business is done, perhaps leading ultimately to a real increase in electronic trading. "Electronic markets are generally more transparent and they also make it easier to show a clear audit trial," concludes Visconti.