When the European Parliament approved the Investment Services Directive, including the controversial Article 27, hearts sank across the City of London.
Investment banks and brokers fear the article, which requires all systematic internalizers to execute orders at the quoted price, is a backdoor concentration rule that will force volume on to exchanges by making it uneconomical to trade off exchange as principal for a large proportion of orders.
The directive must still be adopted by the EU?s Council of Ministers, but it will become a reality. However, the magnitude of the article?s impact is uncertain and there is still time to influence key details that could have profound implications.
The definition of standard market sizes is a concern. Firms that trade as principal below the standard size will be required to quote firm prices, effectively turning them into market makers. The standard market size will be calculated as the average value of shares traded over a period of time. A high standard size would require traders to commit capital to ensure prices for a large proportion of trades.
?What we want to see now is that definitions of standard market size are sufficiently realistic so as not to damage liquidity,? says Alan Yarrow, chairman of the securities trading committee at the London Investment Bankers Association.
The estimated range for standard market is between e20,000 and e200,000. The stakes riding on the eventual definition are therefore very high, as a mark of e20,000 would exclude the majority of institutional business done in London, while e200,000 would account for a sizeable proportion.
If the definition is towards e200,000 then traders will have to develop systems to enable them to quote as market makers. Some traders estimate that a proper market-making service would require as much as five times as many people. Those costs alone could amount to first-year costs in the tens of millions of dollars for large firms.
Firms will also be required to provide best execution. Brokers will not be able to offer worse prices than the ones they quote and they will only be able to trade as principal up to the standard size if they beat the exchange price. Internalization will only be permitted if best-execution criteria are met.
?People think of Article 27 as binary,? says Rob Moulton, managing associate at law firm Linklaters ?Either it hits you or it doesn?t. Being partially affected by Article 27 is almost as bad as being fully affected.?
More consultations are scheduled for June so banks may have lost the war but could still claw back some ground.
