As if the steady onslaught of financial services regulation such as Sarbanes-Oxley and Basel II were not enough, the forthcoming Markets in Financial Instruments Directive (Mifid) will add yet a further layer of legislative complexity for compliance-weary IT people.

Mifid, due to arrive early next year, is a European Union directive that aims to create a single, cross-European financial services market that should, in theory, lower the cost for banks doing business in other countries.

But only two per cent of financial institutions are prepared for the Mifid compliance deadline, according to Forrester Research analyst Thomas Raschke.

‘The financial community needs to start planning,’ he says. ‘It is no good worrying about the regulations when next year comes, because that will be too late.’

Missing the deadline will mean that firms will simply not be able to operate, says Raschke, and he warns of the danger of relying on a further postponement, in the form of the six-month grace period after the initial compliance deadline.

‘Dealing with compliance when the deadline arrives is a dangerous strategy, because these regulations require a great deal of internal preparation,’ he says.

Dresdner Kleinwort is one investment bank that is already prepared for compliance, according to Steven Ashton, global IT business manager, who says the firm is preparing itself for the IT requirements of Mifid.

‘We are certainly in a state of preparedness and we’re heavily engaged internally and with our peer group to try to make sure we have a sensible response,’ he says.

‘I think everybody has recognised that this is something that affects the City and the whole banking environment, so everyone is taking it very seriously. We have set up a segregated project to cover the business – and the subsequent operational and IT requirements of Mifid.’

Dresdner Kleinwort was among the financial institutions that were required to start planning for Mifid when the directive was adopted in April 2004 by the European Parliament.

The directive was introduced to replace the Investment Services Directive (ISD). The implementation deadline for all 25 member states is set for 30 April 2007, with a period of grace to November 2007.

The race for compliance is an issue for firms and governments alike, but according to analyst Gartner the risk is not that firms will fail to make the deadline, but that national governments will not pass the legislation in time.

This was the concern of Charlie McCreevy, the European commissioner for internal market and services, when he warned recently that the Commission will launch infringement procedures against member states failing to make the necessary adjustments to their national laws for timely Mifid compliance.

He also said that member states failing to transpose the European directive into local legislation on time could face legal action by market participants in their own national courts, and that a delay would be a ‘high-risk strategy’.

The final version of the Mifid rulebook – containing 73 articles and applying to all investment firms and asset classes in the EU – will be issued to firms at the end of January 2007, leaving just under a year until they face the force of law if they are not compliant.

The Financial Services Authority (FSA) is the UK government body charged with the implementation of these rules, and the dissemination of advice to the financial services industry on how to prepare for the compliance deadline.

The regulator says companies have the information necessary to be well under way in their compliance preparation.

‘The final version will show firms the shape of the regulation, and they could have been preparing within reason. The FSA has done a lot of awareness-raising in the City in the past six to nine months,’ says FSA spokesman David Cliffe.

‘We said last year, and earlier this year, that firms should be preparing. We are reminding them that they need to be focusing on it. But because much of the directive was not settled until quite recently, we were consulting on a best-efforts basis of what we actually had to go on.’

This outline of Mifid objectives was seen broadly as protecting investors by enhancing the transparency and integrity of the financial system, and ensuring high quality of investor transaction execution by imposing a best-execution obligation.

The best-execution edict requires firms to obtain the best possible deal for their clients in terms of price, cost, speed and likelihood of execution and settlement.

‘Best execution won’t actually be outlined until the final paper comes out at the end of next month,’ says Cliffe.

The issue of best execution has caused concern across all Mifid stakeholders, including trade body the Futures and Options Association (FOA), which rejected the FSA’s proposals to use benchmarking to address best-execution requirements.

The FOA commissioned consultant KPMG to conduct a report on the impact of strict price benchmarking, and found that the measure would exert significant pressure on existing IT processes and create significant costs.

The findings prompted the FOA to urge the regulator to allow firms discretion in determining how to measure best execution in dealer markets.

Rob Nieves, KPMG director and co-author of the report, says there is a technical impact in implementing the benchmarking approach.

‘Capturing third-party market information, and the debate over how frequently this should be done, will affect IT. Whether it is captured in real time, sporadically during the day, or once a day will depend on how prescriptive the FSA will be about the requirements,’ he says.

‘If we are successful in persuading the FSA not to be prescriptive about benchmarking, it will reduce the amount of data that needs to be captured, stored and maintained. Firms needing to plan will either have to take a best guess or wait, even if this creates some risk in relation to the 1 November 2007 deadline.’

Even though benchmarking has created the most speculation about Mifid of late, Anthony Belchambers, chief executive of the FOA, says that if organisations are to meet the Mifid deadline, the FSA must allow them to concentrate resources on implementing the essential parts of the directive.

Belchambers is also chairman of Mifid Connect, an alliance of industry bodies that was launched earlier this year. In August it issued the first part of its Mifid Survival Guide, aimed at helping firms come to terms with the new requirements.

‘The debate about price benchmarking in dealer markets has been an unfortunate distraction to the core objective of achieving compliance,’ he says.

‘No one size fits all, and that applies to benchmarking as well. No single IT solution will fit the requirements either.’

The need for more flexibility and clarity is echoed throughout the industry, says Ash Saluja, partner in financial services law firm Cameron McKenna. According to Saluja things will be made clearer by the FSA’s recently published ‘reforming conduct of business’ paper.

‘This regulation forms the rules that firms must comply with on a day-to-day basis when dealing with customers,’ says Saluja. ‘It is the FSA’s final rules on what Mifid will look like.’

The rules will go through a consultation process until the final version comes out at the end of January 2007.

‘The paper will deal with how firms should demonstrate best execution, what information they need to keep after a financial transaction, and in what form it has to be stored,’ says Saluja. ‘The IT impact will be significant.’

The paper on conduct of businesses should further clarify the FSA’s recommendation of price benchmarking as the method for achieving best execution.

‘To produce a price benchmark you have to assure accuracy in real time – it is a lot of work, which will lead to extra cost for IT departments,’ says Saluja.

According to Gartner, 75 per cent of the cost of introducing Mifid will go towards IT and the other 25 per cent on personnel and change management, which means IT departments already have a heavy cost burden to bear even without the extra benchmarking processes.

Saluja also sees the new regulation as encouraging trading off exchange on other execution venues, which he calls mini-exchanges, which are seen as a more efficient way of running the market.

‘Certain stock exchanges have monopolies over dealing shares,’ he says. ‘For example, you have to deal over a French exchange for a French equity, and only local French brokers have access to that exchange, which is a barrier to competition.’

Gartner analyst Peter Redshaw acknowledges how Mifid formalises the regulation of multilateral trading facilities, but is more interested in its other effects.

‘I would like to see how derivatives will cope. Before Mifid, they were pretty much unregulated and didn’t come under the scope of ISD,’ he says.

‘Mifid could create a two-tier market, accelerating a development that is already taking place: large companies trading many instruments while smaller firms concentrate on niche products.’

Gartner believes that companies with many product lines could find that the investment they need to make to become Mifid-compliant will not be justified by the expected return, and will divest certain product lines.

‘Many small players will do just enough to avoid prosecution. Other firms will see it as an opportunity and make a huge investment, and that might even mean buying a small exchange,’ says Redshaw.

Such an approach is best demonstrated by a group of leading investment banks, which earlier this year formed an alliance to capitalise on the part of Mifid that allows trade reporting to any registered compliant entity rather than enforcing reporting to the main exchanges.

The aim of Project Boat is to create a European trade and market data dissemination platform to rival other exchanges.

Project Boat is expected to substantially reduce the cost of market data for investment banks by enabling them to save on trade reporting fees and market data as well as selling their own data.

Redshaw sees different approaches among companies. ‘Some are spending the absolute minimum possible, seeing it as pure overhead and wanting as little to do with it as possible, hoping that it will all go away. Others are making big investments to change the whole nature of their business,’ he says.

‘Then there are those that will outsource the whole problem so that whoever is doing their brokerage and dealing is Mifid-compliant. They will get them to do as much of it as possible so they are left with only a bit of extra client reporting and classification.’

Whatever the approach, Mifid is not something that firms can afford to ignore.

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Further reading:

Mifid plans may put pressure on IT