MiFID II Explained: Key Regulations and Impact in the EU

What Is MiFID II?

MiFID II represents a landmark regulatory framework introduced by the European Union in 2018 to enhance investor protection, increase transparency, and standardize practices across EU financial markets. Emerging in the wake of the 2008 financial crisis, it addresses key areas such as service models and trading venues to restore confidence and ensure fair practices. By replacing and expanding upon MiFID, MiFID II targets improved oversight and increased transparency across all financial services.

Key Takeaways

MiFID II is a comprehensive European Union regulation introduced in 2018 to enhance market transparency and protect investors.
The regulation extends oversight to virtually all asset classes and financial professionals in the EU, including off-exchange and over-the-counter trading.
MiFID II mandates greater transparency and disclosure in costs, aiming for fairer competition and investor protection.
Strict reporting requirements and increased scrutiny on high-frequency and algorithmic trading are central components of MiFID II.
The EU plans further updates to MiFID II, including banning payment for order flow and enhancing centralized data feeds.

In-Depth Look: MiFID II and Its Broader Implications

MiFID II amends the original Markets in Financial Instruments Directive (MiFID) from a decade before. It rolled out on Jan. 3, 2018, six years after the European Commission, the EU's executive branch, adopted the legislative proposal. MiFID II aims for greater transparency in member states, while the Markets in Financial Instruments Regulation enforces rules for EU financial institutions. Colloquially, MiFID II is used for both, and we'll use the term to cover both EU enactments in what follows.

The original MiFID went into effect in November 2007. The global financial crisis exposed its weaknesses soon after. Critics said it focused too narrowly on stocks, ignoring fixed-income vehicles, derivatives, currencies, and other assets. MiFID also did not address dealings with firms and investment products from outside the EU, leaving rules about those to the discretion of EU member nations.

MiFID II standardizes oversight of the financial industry among member nations and greatly broadens the scope of the EU's regulation of securities markets. In particular, it imposes more reporting requirements and tests to increase transparency and reduce the use of dark pools, private financial exchanges that allow investors to trade without revealing their identities, and over-the-counter (OTC) trading.

MiFID II extends earlier requirements to include stocks, commodities, futures, and currencies. If a financial product is available in the EU, it is covered by MiFID II—even if, say, the trader wishing to buy it is located outside the EU.

Important

That's the cost EU companies spent preparing for MiFID II, according to the Boston Consulting Group, the Wall Street Journal reported.

MiFID II covers virtually all aspects of financial investment and trading and all financial professionals working in the EU. Bankers, traders, fund managers, exchange officials, and brokers and their firms all have to abide by its regulations, as do institutional and retail investors.

MiFID and MiFID II: Key Differences

MiFID

Applied largely to equities markets
73 articles
Drafted in 2004 and became law from 2007 to 2018
Did not address dealings with firms or products outside the EU

MiFID II

Applies to all types of securities and derivatives
97+ articles
Proposed in 2012 and in force since 2018
Applies to any firms wanting to access and trade in EU products, regardless of where they are based

Essential MiFID II Regulations and Their Impact

MiFID II introduced major changes to trading and investing. Here are some key changes:

Regulated Trading

A major goal of MiFID II was to move trading out of the shadows from over-the-counter (OTC) trading and dark pools to regulated trading platforms. MiFID II created a new trading venue, the organized trading facility, to capture previously unregulated trades. In addition, investment firms that want to execute client orders must be a multilateral trading facility (MTF).

MiFID II limited the trading volume of a stock in a “dark pool” to 8% of the total trading volume of that stock anywhere over 12 months. Such pools are private financial exchanges for trading securities that allow institutional investors to trade large blocks of securities without any details being made public until later.

Dark pools are meant for large trades without market impact, but this makes them hard to oversee. MiFID II aims to balance the need for privacy in large transactions that could be contravened by publicity and the market and the public’s need for transparency and information on trading activities.

Transparency

Transparency was another major goal of the financial legislation. For starters, regulated markets and MTFs are required to publish the bid and offer prices of securities continuously. But the legislation goes much further.

Banks and brokerages can no longer charge for research and transactions in a single bundle, making it clearer to clients what each costs individually and hopefully improving the quality of research available to institutional and retail investors alike.

This sounds quite technical, but the effects wouldn't be if the legislation's aims were met:

Transparency in costs: MiFID II ensures greater transparency by separating the charges for research and transactions. Investors can now see exactly what they are paying for each service, giving them better information when deciding which services they want to pay for.
Quality of research: Separating charges could improve financial research quality for investors, though it's uncertain if this has happened. The idea is that when research costs are explicitly charged, researchers have an incentive to produce higher-quality work to justify their expense to clients.
Fair competition and investor protection: The separation of charges could foster fairer competition among service providers and protect investors from being overcharged. It also prevents investors from unknowingly subsidizing research costs through transaction fees, even if they do not directly benefit from the research.

Investor Protection

MiFID II restricts the inducements paid to investment firms or financial advisors by third parties for indirect access to their customers. This is meant to reduce major conflicts of interest when banks and investor services offer advice and services. These must now be offered in the client's best interest, not unknown third parties—for example, firms paying brokerages commissions on clients they sign up for their funds.

Without such regulations, there's a risk that financial advisors might recommend products or services not because they are the best options for their clients but because they offer the most lucrative commissions or other benefits to the advisors.

Investment firms must now do whatever is necessary to achieve the best results for their clients. That includes being upfront about commissions and fees.

Reporting Requirements

Investment firms must give regulators reports containing the details of each transaction they execute by the following day. They also must keep records of all communications, including phone conversations. This enables regulators to monitor potential market abuses better.

Transaction reporting is not just required for sell-side firms, such as brokers. The counterparties who initiate the trade also must do so.

Commodity Speculation and High-Frequency Trading

MiFID II increases scrutiny on algorithmic and high-frequency trading to boost market transparency and fairness. Due to the regulation, firms had to alter trading strategies, invest in compliance, and keep detailed records. Let's break this down further:

Transparency: First, MiFID II requires detailed reporting on trading data, including the algorithms and strategies used in HFT. This aspect of the legislation gave regulators and market participants a clearer understanding of trading activities and the ability to identify manipulative or abusive strategies.
Testing algorithms: Under MiFID II, trading venues and investment firms must have algorithms that are resilient, do not contribute to market abuse, and comply with regulations. Investment firms must also keep detailed records of their testing procedures and results. In sum, the algorithms should be able to handle very different markets, including those with high volatility and unusual conditions. The algorithms also shouldn't create errors that could lead to disruptions or generate false or misleading market signals. The algorithms were also intended to help manage risk by preventing erroneous orders and limiting the firm's exposure to risk. Since the algorithms must comply with the regulatory framework set by MiFID II, they are to be designed so their activities can be easily monitored, reported, and audited.

Market-making rules: The rules place strict guidelines on firms using algorithmic trading for market-making strategies. These firms must deliver continuous liquidity under formal agreements with trading venues. The aim is to prevent illiquidity in the market, particularly during periods of high volatility.
Tick size regime: MiFID II introduced a standard tick size across the EU. This regulation affects HFT strategies that rely on profiting from small price differences.
Anti-fraud measures: MiFID II also enacted rules prohibiting practices like quote stuffing, which involves placing a large number of orders rapidly and canceling them to manipulate and confuse the market, and other measures to deliver a level playing field, not just among HFT participants but also between those engaged in HFT and others in the market.

Future of Financial Regulations Post-MiFID II: What's on the Horizon?

The law mandated a review that began in 2020 of its effects on the EU's financial markets. In October 2023, the EU finalized changes highlighted in the review to put to a parliamentary vote. The changes to MiFID II aim to increase transparency and ban conflicts of interest. Here are some of the changes in store for MiFID II:

Consolidated Data Feeds Across the Bloc

The EU plans to create consolidated tapes to gather market data from multiple platforms. This aggregation aims to give institutional and retail investors easier access to the latest data on the volume and prices of trading in securities.

No More Payments for Order Flow (PFOF)

This change would ban brokers from being compensated for directing client orders to specific trading platforms. Some EU member states where the practice is prevalent have been granted an extension until 2026 to enforce this ban. The change also aligns the EU with markets in the U.K., which already banned PFOF.

Emergency Measures in Place

The EU's regulated markets will be required to have plans to temporarily pause or limit trading during emergencies or when there's a significant price fluctuation in a financial instrument over a short period. In extraordinary circumstances, the markets should be able to cancel, change, or correct any transaction.

What Is a Dark Pool?

Dark pools are private asset exchanges designed to supply additional liquidity and anonymity for trading large blocks of securities away from the public eye. They offer price and cost advantages to buy-side institutions such as mutual funds and pension funds, which claim that these benefits ultimately accrue to the retail investors who invest in these funds. However, dark pools’ lack of transparency makes them susceptible to conflicts of interest by their owners and predatory trading practices by HFT firms.

What Is the U.S. Equivalent of MiFID?

According to the World Bank, the federal rules most comparable to MiFID are the following:

The 1934 Securities Exchange Act: This act established the Securities and Exchange Commission (SEC) and granted it broad authority over the securities industry, including the power to register, regulate, and oversee brokerage firms, securities, and exchanges.
The 1998 Regulation Alternative Trading System: This specified rules for alternative trading systems, requiring them to register with the SEC and adhere to certain regulations.
The 2005 Regulation National Market System: Designed to modernize and strengthen the U.S. system for equity trading, its key components include rules that promote fair access to market data, protect investors from executing trades at inferior prices, and increase transparency.

How Did Brexit Change MiFID II in the U.K.?

Post-Brexit, the U.K. no longer needed to align with EU regulations, including MiFID II. Initially, the U.K. incorporated much of MiFID II into its law, providing needed continuity and stability in its financial markets at a turbulent moment.

Since Amsterdam’s stock market took over from London post-Brexit as the top trading market in the EU and U.K., the U.K. has been looking for ways to put its markets front and center in the region.

The U.K.’s push has been toward “sustainable” deregulation, including the so-called Edinburgh reforms announced in December 2022 and further proposals in December 2023, which some hoped would surgically remove all vestiges of EU rules left in its financial system.

Thus far, the U.K.’s room for maneuver has not been as capacious as Brexit promised, given the need to prevent post-2008 backsliding and to remain aligned with global standards to engage in the global market.

The Bottom Line

MiFID II revolutionized EU financial markets by enforcing comprehensive regulations that enhance transparency and investor protection. Key reforms include curbing over-the-counter and dark pool trading, thereby promoting accountability and fair competition. The directive standardized trading conditions for numerous financial instruments, extended transparency in transaction costs, and eliminated conflicts of interest, ensuring that financial advice prioritizes the client’s interest over third-party incentives. Furthermore, MiFID II scrutinizes high-frequency trading algorithms, aligning them with mandatory transparency and fairness standards. As the financial landscape evolves, MiFID II remains a critical benchmark for regulatory practices within the EU and globally.