By Mark Spanbroek, Vice Chairman, FIA European Principal
It’s February 2022. Mifid II legislation has
been in force for five years. Five years which have reshaped
our financial market structure. How does the market
The last five years have seen the markets become less
diverse. There are very few small participants in the markets:
the regulatory burden has led them to merge with other, larger
participants, or driven them out of Europe all
Some of them trade just OTC so we don’t see the
effects of their participation. On the lit markets, the
reduction in the number of market participants, and orders,
means that there are fewer market makers providing liquidity,
risks are higher so spreads are wider.
This makes it harder for end customers to get a good price
on the lit markets: leading to institutions moving their
business away from the centralised marketplace and towards
Tick sizes have widened for the majority of liquid share
symbols, and this has also helped to push orders away from lit
markets. It’s been a steady downward spiral
movement, and it’s still going.
We’re all wondering how we failed to spot this
risk in February 2015.
This brings me back to today. It is important to me, as it
is to all market participants, that what we build today in
Mifid II creates stronger, sustainable markets, and
doesn’t lead us to look back on today and wonder
how we could have been so short-sighted.
My concern is with liquidity in the lit markets: my feeling
is that the current draft regulation goes too far in
places, running the risk that the regulators of today may be
paving the way towards dysfunctional markets in 2022.
First let’s remind ourselves what liquidity is.
The liquidity of any product depends on how easy or hard it is
to buy /sell an asset quickly without affecting its price. In
other words it’s dependent on the number and
quality of those market participants who share their prices,
order sizes, and update behavior with other participants.
Therefore the presence of liquidity is related to the quality
and quantity of information available.
Transparency is central to liquidity: there may be
institutions to trade with in a dark pool, but you
can’t guarantee the liquidity as you
don’t get publicly reported orders and prices for
each product (stock, bond, future, options, ETF).
Without the transparency to see the whole ecosystem of the
market, bid-ask spreads widen because those providing them
cannot see the factors influencing the prices around them
(number of orders, order size, etc.).
The number of market participants is key to good liquidity:
we need enough competing participants of each and every
discipline (i.e. market makers, institutional investors,
investment banks) to keep the prices accurate, ensure efficient
transfer of risk, and keep the spreads tight.
Smaller firms often provide passive liquidity supply, as
opposed to the higher risk strategy of formal liquidity
provision, but it is likely under Mifid II that they will now
be compelled to provide liquidity on a formal basis, which many
cannot afford. As a result, this source of liquidity will
be lost to the markets.
A further threat to small firms under the new regulatory
regime comes in the form of capital requirements and compliance
costs. With proposed requirements such as full time dedicated
compliance officers, duplicate hardware lines, and full
business continuity back-up facilities, the burden on small
market participants would be disproportionate and potentially
destructive. Smaller market participants may struggle to
maintain a viable business in Europe under these pressures and
choose, instead, to exit the European market.
In a similar vein, there are concerns that the Mifid II
proposals around Order to Trade Ratios will restrict
competition between venues. The proposals fail to consider the
impact of OTRs on a new trading venue: new platforms are only
able to start business by quoting prices without trades as
there will not yet be the liquidity to fill them. If OTRs come
into force, fewer participants will be able to afford to add
liquidity to new markets by starting to quote there.
There is also a potential risk that under Mifid II the
number of clearing houses will decrease, meaning less choice
for consumers. Banks once committed themselves to clear
business for market participants, but because of the increase
in capital requirements to do this, some banks have ceased
clearing, and those still doing so are under
With fewer clearing houses in the markets the risks are
concentrated in the few still operating: creating a ticking
With fewer clearing houses in the markets the risks are concentrated in the few still operating: creating a ticking time bomb.
Dark pools also provide competition to the central markets:
they’re good for executing large institutional
orders without moving markets, but they were intended as a
supplementary trading venue to the centralized markets and must
remain that way.
The proposals to increase tick sizes will only serve to
drive business into the dark: by forcing spreads to widen it
will become easier for systematic internalisers and dark
pools to improve on price.If too much business is transacted in
the dark, market makers will not receive enough information to
quote accurately: spreads will widen further and liquidity will
Central markets are the main driver of a well-functioning
economy, in which risk transfer can take place in an efficient
and transparent way, but proposed regulation risks driving the
markets to internalization and order crossing, which could have
This brings us back to where we started, looking in 2022 at
a reduction in the number of participants and technological
innovation, leading to wider spreads, more internalized
business and fewer market makers: an interminable downward
spiral away from a liquid centralised marketplace.
This outcome would run contrary to Mifid
II’s original endeavour to ensure trading across
all asset classes occurred as much as possible in open and
In a scientific experiment it is customary to change a
single variable at a time, to conclusively prove the
relationship of cause and effect between change of input and
change of outcome.
While we can all appreciate that to do so with the markets
would be impractical, so many changes are being made through
Mifid II that it seems impossible that we will be able to
look back and accurately determine which elements of the
legislation proved to be good or bad.
We will only have a single litmus test: have we preserved
liquidity in our markets or not? This is the responsibility
held by all our regulators today, not just 'the
market’, and we will all look to see the results
For more information on the types of market participant and
the structure of today’s markets, see: https://epta.fia.org/articles/who-are-participants-modern-markets