Deeply Unsatisfactory

Article by Keith Boyfield in The Wall Street Journal

This year is "crunch time" for financial services in the Europe Union. Officials at the European Commission are working flat-out to implement ambitious plans to create an integrated, continent-wide single market. The idea behind the so-called Financial Services Action Plan (FSAP) is to promote competition and efficiency across the 27 member states. A great idea; only it's unlikely to work.

Let's look at one of the main problems Brussels is trying to resolve. A cluster of "Club Med" countries, notably France, Spain and Italy, have traditionally insisted that all securities transactions must be funneled through domestic exchanges. So currently, if one wants to trade shares in a company registered on the Spanish bourse, for example, one must do so through a member of the Madrid stock exchange. One of the core pillars of the Commission's financial action plan, the seemingly innocuous acronym MiFID (Markets in Financial Instruments Directive), is designed to change that. MiFID would abolish this monopoly and enable trading in such shares to be spread between many more venues, such as platforms set up by investment banks, thereby delivering greater choice and lower fees to consumers. It would also introduce far greater transparency and consumer protection standards than has generally been the case in many EU national markets.

That's the theory. But these promised benefits may prove elusive. That's because MiFID is the product of a myriad number of political compromises hammered out between on the one side a loose coalition of member states who broadly support the concept of free markets, such as Ireland, the U.K., the Netherlands and Sweden, and the Club Med countries mentioned above who generally reject the idea.

In a deal negotiated between those two opposing blocks to adopt the MiFID directive in principle, they added no fewer than 71 optional amendments, which member states could apply at their own discretion to impose additional obligations on financial service participants beyond MiFID's minimum standards. One such amendment, for example, enables a member state to apply price transparency requirements on financial instruments other than shares, notably corporate bonds, many of which tend to be illiquid. As Bob Fuller, CEO of the about to be launched pan-European securities exchange, Equiduct, told me, "Imposing pre-trade transparency on illiquid bond markets will lead to even less liquidity." Italy, for one, appears to be quite keen to do so, and if it goes ahead, this will be the end of any hopes for a consistent implementation of MiFID.

Furthermore, there are other signs that MiFID will not be rigorously implemented in every member state. Besides the staggered adoption of the directive across the EU, a recent survey by the Committee of European Securities Regulators (CESR) revealed that the Czech Republic, Estonia, Finland, Hungary, Lithuania, the Netherlands, Sweden, Slovenia and Slovakia are unlikely to meet the November target date for implementation. What's more, certain countries have exceedingly poor records for implementing FSAP measures at all. Latvia, for example, appears to have largely ignored the Second Money Laundering Directive even though a Third Directive has now been passed by Brussels.

Worries about MiFID implementation are not helped by the slow progress made by CESR, which was asked by the Commission to issue guidelines on the consistent application of MiFID in each member state. Among the issues where CESR is well behind schedule are standards on transaction reporting, best execution procedures and internal governance. A survey by London-based EA Consulting shows that 93% of U.K. financial institutions polled expect that MiFID requirements will not be consistently implemented in every member state.

Linked to fears of uneven implementation are concerns about equally uneven enforcement standards. While London's regulatory authority is likely to enforce MiFID zealously, the same cannot be said of other member states. Some countries may simply not have the manpower to do so or deliberately choose to ignore the rules to give its industry a competitive edge. Leaving aside new entrants Bulgaria and Romania, certain member states, particularly Greece, Luxembourg and Portugal, have a poor reputation for the transposition and enforcement of financial EU regulations. Such lax implementation is almost certain to be noticed by firms seeking to capitalize on regulatory arbitrage, thereby maximizing returns in less strictly regulated markets. The European Commission must be faulted for pinning unrealistically high expectations on the uniform implementation of the FSAP.

If member states fail to enforce the rules, there will of course be mounting calls from Brussels for a single financial services regulator for the EU. Many financial players in London would certainly not like this idea but it may be difficult to resist if member states do not play by the rules. As former Chancellor of the Exchequer Nigel Lawson observes, it is not sufficiently recognized that healthy competition in regulatory systems is as beneficial as it is elsewhere.

Apart from implementation and enforcement problems, recent studies suggest that compliance costs are likely to be substantial, whereas estimated benefits remain hazy and long-term at best. The U.K. Financial Services Authority suggests that "first round" benefits attributable to MiFID in Britain may amount to £200 million a year. But compliance costs are likely to be far higher, about £1bn by 2010 in the U.K. alone. My own research for Open Europe, a think tank, suggests that figure to actually stack up to several billion pounds. For instance, IT implementation costs alone are likely to amount to £1.2 billion, while data storage costs -- MiFID requires firms to store transaction data for five years -- will also add hundreds of millions to the eventual bill.

Such staggering sums raise doubts about the wisdom of adopting MiFID in the first place, particularly if it fails to establish a single EU market in financial services. U.K. financial services firms have to face major changes and expenses for an initiative which has been subject to no comprehensive cost-benefit analysis. This situation, as FSA's Sir Callum McCarthy notes with splendid British understatement, is "deeply unsatisfactory."

Keith Boyfield is an IEA Fellow and Chairman of the IEA's Shadow Regulation Committee.

See also June 2006 issue of the Economic Affairs Journal
Better Regulation Without the State
, guest edited by Keith Boyfield.

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