Financial Instruments Directive Research Articles

EU’s sustainable finance disclosure regulation: does the hybrid reporting regime undermine the goal to reorient capital to climate action?

ABSTRACT Disclosure and reporting are cornerstones of the European Union’s sustainable finance agenda with the goals of reorienting capital flows towards climate and other sustainable investments and minimizing greenwashing. A key component of the regulatory framework is the Sustainable Finance Disclosure Regulation (SFDR), which requires fund managers to calculate and disclose a ‘sustainable investment’ (SI) percentage, aggregating exposure to activities contributing to climate mitigation and adaptation and the other environmental and social sustainability objectives of the European Union. In turn, financial advisors must use SI percentages when advising customers under the Markets in Financial Instruments Directive II. Defining ‘sustainable investments’ in a robust and consistent way is crucial to the effectiveness of SFDR. Based on a review of the regulatory texts and financial sector participant observations this policy analysis article explores the overlapping guidelines framing how market participants are allowed to define sustainable investments, and the implications for achieving the goals of the sustainable finance agenda. The analysis suggests that the ‘unintentionally hybrid’ SFDR regime may perversely incentivize fund managers to forgo the use of the highly detailed EU Taxonomy rules-based approach that precisely defines climate-related ‘substantial contributions’ and apply the vague principles-based approach found in SFDR Article 2.17. This would allow each financial actor to define and determine independently what constitutes a sustainable investment, circumventing the robust, if imperfect, climate-related rules of the EU Taxonomy. The SFDR regime therefore risks undermining the European Commission’s stated goals of increasing capital allocation to sustainable activities and eliminating greenwashing. Key policy insights: A sustainability disclosure regime allowing the choice between robust rules and vague principles risks creating opportunities for greenwashing and reduced comparability. Fund managers are likely to select definitions that are least difficult to apply and maximize Sustainable Investment percentages. The current EU regime risks tacitly sanctioning the use of weak metrics, in turn slowing the reorientation of capital towards climate-related and other sustainable investments. The EU must at a minimum provide binding guidance on interpreting Article 2.17, require equal prominence for both SI percentages and EU Taxonomy-alignment scores, as well as address the usability issues of the existing Taxonomy.

Disruption in the Market for Information: MiFID II and Investor Relations

Our study addresses the complex processes by which actors in the market for information reposition themselves and recalibrate their work in response the introduction of the Markets in Financial Instruments Directive (MiFID) II, which regulated a wide range of issues on information flows and payments for research in capital markets. Using interviews and surveys of UK investor relations (IR) professionals we explore how the activities and practices of IR professionals, and their relations with sell-side analysts and investors, have changed. We find that the operational processes within the market for information have been materially disrupted and observe an increase in the importance and relevance of the IR function both internally (within their organizations) and externally (in the field of investment advice). We provide evidence of extensive ‘jostling for position’ in the field which is perceived to have resulted in the (at least partial) disintermediation of the sell-side and increased direct ‘interlocking’ of investors and IR professionals in their engagement and information communication practices. We report on a changing information market paradigm (sequencing of communication) - where the traditional information and relational intermediation roles of sell-side analysts are now increasingly contested and assumed by IR professionals.

English

Customer profiling tools have been introduced in recent years to protect investors against the increasing complexity of financial instruments. Advisor experts have to combine measures of finance and behavioural finance studies in their evaluation. The need to integrate different competences and compare complex criteria naturally leads to the modelling of the portfolio selection problem as a group decision problem. The Analytic Network Process (ANP) is a useful technique that helps decision-makers evaluate the available alternatives and aggregate their professional knowledge. In this context, the Reaching Consensus Process (RCP) is crucial for the validity of choices due to the strong sensitivity of the ANP to the decision maker's judgement. However, the RCP may be affected by the behavioural characteristics of experts, the vulnerability of judgements and the uncertainty that characterises the decision-making context, leading to unbiased judgements that are not based on different expertise. Similarly, without the involvement of more experts, the process could be inefficient due to the sensitivity of the ANP decision-maker’s judgement. In order to maximise the aggregation of experts' knowledge, to minimise the influence of the individual in quantifying the relationships between criteria and alternatives, and to preserve the impartiality of evaluations, the present paper discusses RCP through Choquet’s discrete integral. This aggregation captures the non-linearity of preferences and includes the fuzziness of judgments. Thus, there is no need to reach a consensus when evaluating the criteria: each expert manages a single ANP whose synthesis are aggregated using Choquet’s discrete integral. In this sense, the aggregation defines an unbiased consensus which mitigates the sensitivity of the ANP to the preferences of the decision-maker. The methodology is applied to a case study in which several experts evaluate investment alternatives of an individual, simultaneously incorporating behavioural criteria and Markets in Financial Instruments Directive (MiFID) client profiling criteria.

‘Nobody Is Proud of Soft Dollars’: the Impact of MiFID II on US Financial Markets

Abstract Scholars and policy makers have long debated whether securities firms should be allowed to bundle the cost of execution services with the cost of research. Investor advocates condemn the practice whereas industry representatives defend it. In 2018, as part of the Markets in Financial Instruments Directive II (MiFID II) legislative regime, the EU forced the unbundling of commission charges, diverging from US legal standards which still allow ‘soft dollar’ payments for research. The EU’s unbundling regime has challenged global financial services firms, which must now comply with conflicting rules across national boundaries. For more than five years, the US Securities and Exchange Commission provided temporary no-action relief to facilitate compliance with MiFID II, but that relief expired in July 2023, presenting an opportunity to reconsider the impact of MiFID II’s unbundling regime and its implications for US regulators and investors. While this article takes a critical view of soft dollar practices, the story of MiFID II presents contested issues of policy analysis as the agency costs inherent in bundled commissions could be offset by the public benefits of additional research. Unbundling also offers a noteworthy example of an innovation in capital markets regulation flowing from Europe to the United States rather than the other way around.

Research unbundling and market liquidity: Evidence from MiFID II

AbstractThe second Markets in Financial Instruments Directive (MiFID II) mandated the unbundling of payments for research and trading. This research explores whether the impact of MiFID II differs between large and small firms in terms of analyst coverage and stock liquidity. Focusing on the UK stock markets we find a significant drop in analyst coverage on the Main Market, which leads to a deterioration in market liquidity. In contrast, the requirement of AIM firms to retain a Nominated Adviser, who often provides research coverage, has mitigated the impact of MiFID II.

An Analytic Network Process to Support Financial Decision-Making in the Context of Behavioural Finance

Following the financial crisis of the last decade and the increasing complexity of financial products, the European Union has introduced investor protection tools that require professionals to carry out a client profiling process. The aim is to offer products that are in line with the characteristics of the individual. The classes of variables for comprehensive profiling are obtained by matching the elements proposed by the Markets in Financial Instruments Directive and studies of classical finance. However, behavioural finance studies, which emphasise the importance of behavioural attitudes, are not clearly considered in this structured profiling. The present paper discusses the implementation of an analytic network process to support financial decision-making in a behavioural context, combining regulatory guidance and qualitative and quantitative evidence from the literature. The Kersey Temperament Model is used as the behavioural model to construct the network cluster that incorporates personality into the valuation. Uncertainty management is incorporated through recent studies in the context of intertemporal choice theory. The functionality of the network is verified through a case study, where two alternatives with different characteristics are considered to meet the same investment objective. The present approach proves how the generated structure can provide strong support for financial decision-making.

MiFID II and the unbundling of analyst research from trading execution

AbstractThe revised Markets in Financial Instruments Directive (MiFID II) requires the unbundling of research payments from trading execution, fundamentally changing the way in which investors typically pay for analyst research in Europe. We examine the effectiveness of the regulation in changing the link between analyst research and trading, the research‐trading link, and the analyst response to this potential change in incentives. Using a difference‐in‐differences research design, we find that forecast frequency, optimism, and accuracy are less associated with the brokerage trading share after MiFID II, suggesting that MiFID II weakened the link between the brokerage share of trading and analyst research. Following MiFID II, analysts in Europe are less likely than analysts in the United States to continue high forecast frequency, optimism, and accuracy for stocks with high share importance for the analyst's brokerage house. We find similar results throughout for buy/sell recommendations. Overall, our evidence suggests that MiFID II is at least partially successful in unbundling research from execution, and impacts both the trading effects and the production of analyst research.

How to undo things with words? Explication and the counterperformative effects of regulation

Policymakers implement regulations with limited capacity to register the unexpected. We argue that unexpected events do occur when regulations are implemented and we develop the concept of explication to account for the performative misfires that generate them. Explication is the organisational process that allows abstract ideas to be transposed into material realities and it allows us to identify how regulatory texts can carry signs and intentions in absence of their authors. We investigate the implementation of Markets in Financial Instruments Directive (MiFID), a regulatory package that generated a market context that was significantly different from what its economic programme sought to achieve. The competitive model underlying MiFID aimed to create a level-playing field among European financial markets but in reality its explication reduced transparency. We make four contributions to organisation studies. First, we show that explication is a source of contingency in implementation. Second, we shed light on the individual and collective hermeneutic performance as the source of counterperformativity. Third, explication brings intention back into the discussion: intention emerges from the unintended consequences borne by regulatory texts from the moment interpretation begins. Fourth, we show how explication can be a widely useful concept in organisation studies because it brings the performativity of language back into material semiotics whilst maintaining a place for contingency.

Reorganizacija mesta trgovanja – usaglašenost novog zakona o tržištu kapitala S MiFID II

At the end of 2021, the National Assembly of the Republic of Serbia adopted the new Capital Market Law, which brought numerous novelties and institutes into the national Stock Exchange Law. According to sample of the Markets in Financial Instruments Directive (MiFID II), the legislator fulfilled a complete reorganization of the existing capital market by introducing new trading venues – organized trading facilities and systematic intermediaries. Additionally, under the infuence of contemporary trends in global capital markets – digitization, platformization and financial innovations, sophisticated trading models like algorithmic trading and high-frequency trading were introduced into national law. Therefore, the aim of this paper is to review and indicate to what extent national law is harmonized with current developments in the capital market, primarily with the MiFID II. Having in mind that the implementation of the Law commenced at the moment of writing this paper, it is still impossible to see the legal scope of the application of the newly adopted solutions in practice and the formation the attitudes of competent authorities regarding new institutes.

Insights into UK investment firms’ efforts to comply with MiFID II RTS 6 that governs the conduct of algorithmic trading

PurposeThe purpose of this paper is to examine the effectiveness of UK investment firms’ implementation of the requirements in Commission Delegated Regulation 2017/589 (more commonly known as “Regulatory Technical Standard 6” or “RTS 6”) that govern the conduct of algorithmic trading activities.Design/methodology/approachA qualitative examination of 19 semi-structured interviews with practitioners working for, or with, UK investment firms engaged in algorithmic trading activities.FindingsThe paper finds that practitioners generally have a good understanding of the requirements in RTS 6. Some lack knowledge of algorithms, coding and algorithmic strategies but have used best efforts to implement RTS 6. However, regulatory fatigue, complacency, cost pressures, governance in international groups, overreliance on external knowledge and generous risk parameter calibration threaten to undermine these efforts.Research limitations/implicationsThe study’s findings are limited to the participants’ insights. Some areas of the RTS 6 regime attracted little comment from participants.Practical implicationsThe paper proposes the introduction of mandatory algorithmic trading qualification requirements for key staff; the lessening of the requirements in RTS 6 for automated executors; and the introduction of a recognised software vendor regime to reduce duplication and improve coordination between market participants that deploy algorithmic trading systems.Originality/valueTo the best of the author’s knowledge, the study represents the first qualitative examination of firms’ implementation of the algorithmic trading regime in the second Markets in Financial Instruments Directive 2014/65/EU.

The role of market operators in scaling up voluntary carbon markets

As the effects of climate change are affecting countries across the globe, companies are increasingly turning to voluntary carbon markets to offset their greenhouse gas emissions (GHGE).1 Carbon markets comprised two types of markets: markets which are embedded in governmental GHGE reduction schemes (compliance markets) and markets that are the result of private initiatives (voluntary markets). Voluntary markets are more and more harnessed by public actors to reduce GHGE, allowing regulated entities to use voluntary credits for compliance purposes.2 However, issues concerning integrity, liquidity and quality are beleaguering these markets, causing inefficiencies and distorting price formation. If voluntary carbon markets are to support climate change mitigation strategies and if supply is to meet the growing demand for voluntary carbon credits (VCCs), these markets need to resolve these issues in order to grow (scale up).3 This article investigates which roles market operators authorized under the Markets in Financial Instruments Directive (MiFID II)4 could play in scaling up these markets. Market operators already facilitate transactions in voluntary markets, but their involvement is relatively limited. Given their experience with operating multilateral systems and providing transparency in markets in financial instruments, they could contribute to the resolution of these issues. The conclusion of this article is that market operators can indeed fulfil several key roles in voluntary markets while observing their obligations under MiFID II.

Does smile help detect the UK's price leadership change after MiFID?

We investigate intraday realised volatility, trading volume, and information transmission following a series of changes to the Markets in Financial Instruments Directive (MiFID) in the UK. We find that multilateral trading facilities attract order flows from the London Stock Exchange (LSE) and hence introduce new dynamics to market provisions, such as volatility and information transmission. In addition, the structure of the order books and market depth changed after the introduction of MiFID in the UK. However, our novel study conveying smile patterns of volatility and volume suggests that the LSE continues to lead the rest of the multilateral venues. This shows that although MiFID has led to market segmentation, there is still clear price discovery among multilateral trading facilities.

RegTech – Potential benefits and challenges for businesses

The last Global Financial crisis in 2008 fuelled the need for regulation to avoid history repeating itself. New regulatory technologies (RegTech) are helping to transform how compliance issues are handled. This study aims to highlight the benefits of RegTech solutions for companies as well as the challenges of adopting these technologies. It also addresses the Markets in Financial Instruments Directive (MiFID) II legislation, which has led to an increase in the number of RegTech companies. Although these systems of technology offer compelling compliance tools, they also pose significant risks. For this reason, this study aims to draw attention to the opportunities and potential pitfalls associated with RegTech and propose recommendations for addressing the challenges related to implementing RegTech solutions.

Inconsistent Risk Profiles within Pan-European Private Banks: Insufficient Transparency for Retail Investors

The Markets in Financial Instruments Directive (MiFID) must protect retail investors and increase risk transparency. To disclose and mitigate investment risks effectively, banks use standardized risk profiles. Through a scenario-based case study, we demonstrate that based on future risk-adjusted returns and volatility, these risk profiles of pan-European private banks significantly differ. Even though MiFID is not subject to bandwidth restrictions, differences could interfere with risk transparency and lead to significant differences in future risk, return, and managed expectations of clients due to profile overlap. This article uses the risk profiles of twelve pan-European private banks. We found significant non-equality among three rebalancing strategies: buy-and-hold, yearly rebalancing, and bandwidth rebalancing. The impact of broader bandwidths in the rebalancing strategy results in a significantly higher risk and return for investors due to greater flexibility in equity weights. Consequently, this article presents inconsistencies in private banks’ risk profiles. Future regulations should address and reconstitute guidelines to mitigate risk discrepancies. The difference in risk and return within the pan-European private banks creates a lack of transparency and does not contribute to investor protection envisaged by MiFID.

The greater the volume, the greater the analyst

Are sell-side security analysts paid for turnover-generating research? Using hand-collected annual income data from tax records in Sweden for the 1997-2007-year period, I show that analysts’ compensations increase in the trading turnover that their recommendations generate. Analysts are paid 0.002 % of broker-trading volume, or approximately 1 % of broker’s commission revenues. The findings empirically validate the previously assumed turnover-compensation link and estimate its magnitude. The results may have policy implications related to the Markets in Financial Instruments Directive.

MiFID II and the Regulation of Multilateral Trading in OTC Derivatives: Is the OTF Fit for Purpose?

Abstract This article identifies barriers to the complete implementation of the organized trading facility (OTF) as a new category of trading venue under the Markets in Financial Instruments Directive (Directive 2014/65/EU) (MiFID II). It argues that attempts to reconcile the competing claims of incumbent regulated markets and dealer banks operating broker crossing networks in the cash securities markets led to a market design that is not suitable for the over-the-counter (OTC) derivatives markets. The result has been that multilateral trading in the wholesale secondary markets has not been incorporated in trading venues, as was intended, and that changes that are better aligned to market requirements are needed. These include reform of requirements transposed from the cash securities markets, such as standardized fee structures, and relaxation of restrictions on interactions between an OTF and other OTFs or systematic internalizers.

Does risk sorting explain overpricing in experimental asset markets?

Sorting according to the gender or cognitive abilities of the traders has been investigated as a potential source of overpricing in asset markets. Here we study if sorting according to risk attitudes matters, motivated by the fact that filtering out risk-averse investors is practiced widely in Europe and is in line with the Markets in Financial Instruments Directive (MiFID) of the EU.Despite the central role of risk attitude in the literature, our study is the first that sorts participants into markets by risk tolerance and tests its effect on overpricing. We show that risk sorting can explain overpricing only partially: Markets with the most risk-tolerant traders exhibit larger overpricing than markets with the most risk-averse traders. In our study, risk aversion does not correlate with gender or cognitive abilities, bringing in an additional factor to understand overpricing.

Implementation of MiFID II investor protection provisions by private banks within the European Union

PurposeWith the introduction of the Markets in Financial Instruments Directive (MiFID), financial institutions are faced with many investor protection provisions; this has a major impact on the day-to-day operations of private banks, which provide investment services to predominately retail or non-professional investors. The purpose of this paper is to determine how MiFID provisions regarding investor protection with respect to suitability are complied with in practice by private banks.Design/methodology/approachBased on interviews with 25 representatives of private banks from 10 different European Union (EU) member states, the researchers have determined how these provisions are fulfilled and associated risks mitigated. Mapping out the suitability requirements of MiFID and comparing them with how these have been operationalised, we arrive at the question of whether this leads to a level playing field and investor protection by different private banks.FindingsAlthough MiFID is trying to achieve a level playing field between the EU member states, this study shows that this has not been achieved in all areas. Investor protection requirements from MiFID are interpreted and operationalised differently. Although these differences are sometimes small, sometimes they are larger and affect the way the investor is served and suitability determined.Originality/valueThis research provides a unique insight into the way private banks in Europe have implemented the MiFID II requirements and gives insight into best practices. For the future, this research can serve as a prelude to in-depth follow-up research on the implementation of EU provisions.

The Supply and Effectiveness of Investor Relations in Insider- vs. Outsider-Oriented Markets

Using annual survey-based investor relations (IR) data for a panel of European companies, we document that the supply and effectiveness of IR varies with country- and firm-level demand. Relative to their industry peers, firms from insider-oriented countries have larger IR staff, which predicts better IR rankings. Better IR is associated with greater visibility, information assimilation, and valuation, with visibility and assimilation being significantly greater for firms from insider-oriented countries. Within such countries, firms with greater outsider orientation have higher capital market benefits. Furthermore, using Markets in Financial Instruments Directive II as a shock to analyst coverage, we find an incrementally larger association between IR and visibility in insider-oriented countries after 2017. Overall, the evidence suggests that the supply of IR in insider-oriented markets has reached a high level, acting as a viable mechanism to improve firms’ information environment. However, within those countries, IR demand still varies significantly, with outsider-oriented firms showing greater IR effectiveness. This paper was accepted by Brian Bushee, accounting. Supplemental Material: The data files and online appendix are available at https://doi.org/10.1287/mnsc.2022.4368 .

Intraday volatility smile: Effects of fragmentation and high frequency trading on price efficiency

In 2007, the European Markets in Financial Instruments Directive ended the national concentration rule. As a result, market fragmentation has accelerated across multiple trading venues. Spatial fragmentation might create opportunities and incentives for High Frequency arbitrageurs to fill the void left by the lack of Reg NMS type order routing requirements in Europe, without neglecting market integrity. This paper examines intra-day volatility and price efficiency through the metric of the normalized volatility ratio for the years 2006, 2012 and 2013 for Euronext Paris, BATS and Chi-X Europe. Our findings show that price determination remains inefficient at market opening due to the complexity of price discovery activity following a period of non-trading and heavy information releases. However, we demonstrate that an active participation of high-frequency traders significantly improves market efficiency at opening session.