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The following guest post is courtesy of Adinah Brown, content manager at Leverate.
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The financial industry in Europe will see significant changes under MiFIDII, the second iteration of financial reforms that were originally implemented in 2007. The new directives have the aim of increasing transparency and accountability among financial companies by making requirements for reporting transactions more stringent. Traders may wonder how these new rules will affect them. There are many traders who are concerned about their ability to produce outsized gains in the face of new regulations and their ability to make private trades. On the other hand, the greater feeling of security created by MiFIDII may encourage more people to invest. Leaving many traders wondering on what side the penny will fall, for them or against them?
The first phase of MiFID, or Markets in Financial Instruments Directive, was adopted in 2007 to regulate investment services in the European Union. MiFID was founded on the principles of transparency, efficiency, integration and fairness. Starting in 2014, these regulations were revised, and MiFID2 was formulated in response to the financial crisis that began in 2008. The new rules were meant to increase investor confidence and to regulate a wider spectrum of trading vehicles.
The MiFID2 requires reporting of transactions from large and small financial institutions. The goal is to ensure that all trading platforms are regulated, with a focus on high frequency trading, derivatives and commodities, which are areas that have received less regulation in the past. One of the effects the MiFID2 will have on trading is the clamping down on secrecy and tighten regulation on dark pool liquidity markets. The goal is that investors will have full knowledge of who they are trading with and under what arrangement. This reform may benefit a number of investors, but some traders may feel that creating more transparency in dark pools will undercut some of the advantages private trading can have on the price of stocks.
With the adoption of the MiFID2, market makers and other trading desks will have to define their operations in the categories available of a Systematic Internalizer, depending on their trading volume.
Dark pools are used by institutional investors to execute block trading in a way that would not directly interfere with the markets. These dark pools have grown in size and scope in recent years, and can be complicated to track, especially regarding the identity of trading partners and the incentives they may receive. The benefit of regulating these dark pools through SI classification, is to keep investors from being taken advantage of by unscrupulous trading partners whose identity is nebulous.
However, the changes will dramatically affect the strategies used by institutional investors to handle a large number of transactions and can prevent them from benefiting from private trading.
Smaller investment firms may equally gain from MiFID2. The regulations aim to level the playing field and prevent larger financial firms from unduly profiting from complex, dark pools they can access easily because of the size of their company and the number of investment professionals they can hire. In addition, it could lower the costs for investors, since investment consultants are required to reveal the amount that is being charged for each service. To the benefit of the industry, the new regulations may reduce the risk of market crashes due as it clamp down on unbridled high frequency trading that artificially drives up or down the price of stocks and create dramatic swings.
Whether the changes are perceived as positive or negative for traders and investors, there is no doubt that MiFID2 promises to affect the entire financial industry in Europe, from brokers and traders to individual investors. Although the increased transparency may change the way dark pools operate and can impact private trades, the regulations may provide greater safeguards to individual investors and create a fairer way for smaller investment firms to compete.