If there is one category of financial instrument that has been most frequently blamed for the financial crisis that plagued US and European financial markets in 2008, it was derivatives. Predictably, governments in both jurisdictions have moved to review the existing regulatory framework and develop new rules that would reduce the likelihood of such a crisis occurring again. In the US, these new rules were actualized by the Dodd Frank Act of 2010 (in full, the Wall Street Reform and Consumer Protection Act).
Across the Big Pond, new rules to tame derivatives and manage risks to European Union financial markets as a whole are set to be encapsulated in MiFID II – an enhancement of the original MiFID (Markets in Financial Instruments Directive) set out by the European Parliament in 2004. There are a number of objectives and consequences common to both Dodd-Frank Act and MiFID II not least of which is the anticipated increased demand for robust data warehouse infrastructure.
We will focus more on the European markets and how this feeds into technology investment by financial market players.
MiFID II is currently work in progress
Whereas MiFID II is still in its drafting stages and unlikely to take effect until 2014 or 2015, discussions and pointers so far indicate that it will be for all intents and purposes an enhancement of the standards set out in MiFID. The aim of the 2008 directive was to enhance financial market transparency and ensure market players manage risks in real time. MiFID placed a substantial strain on many financial services firm’s data warehouse infrastructure as they endeavored to comply with the unprecedented regulatory requirement for real time risk data availability.
The fact that the new directive will require even more transparent and instantaneous data availability can only mean financial market players will need to dig deeper and go for sophisticated data warehouse infrastructure to comply with the regulations. What’s more, the European Parliament is contemplating having the new rules passed as a regulation (known as MiFIR – Markets in Financial Instruments Regulation) and not a directive. The difference? Directives require that member countries later pass in country legislation to operationalize while regulations become law across the European Union as soon as they are passed by the European Parliament.
To put the data warehouse and technology infrastructure repercussions of MiFID II in proper perspective let’s take a quick look at some of the key pillars of the 2008 directive.
Overview of the original MiFID pillars
- Client Categorization – The 2004 directive required that financial investment firms group their clients into 3 categories – retail, professional and eligible counterparties. Each of the 3 categories attracts a different level of protection – retail clients get the highest protection with eligible counterparties having the lowest. It is on the basis of this categorization that financial firms would be expected to assess each client’s suitability for a particular financial markets product. To make the process as scientific, objective and automated as possible, a financial services firm’s data warehouse infrastructure should have the capacity to auto-assign categorization to each client based on a pre-defined set of criteria. That way, the system would flag or block transactions that are not consistent with a client’s MiFID category. Of course, such automated category assigning should also allow for human intervention to manage exceptions and manually resolve categorization conflicts for clients who have attributes that qualify them to be placed in more than one of the three categories.
- Order handling – MiFID 2004 defines specific parameters that must be captured in any client order and indicates conditions under which orders from more than one client should be aggregated. This again requires a robust data warehouse that can accept and correlate client data to ensure decisions made by investment bankers are consistent with the MiFID requirements.
- Pre- and After-trade transparency – On pre-trade transparency, institutions running an order-matching securities trading platform are required to make available in real time the top 5 best buy and sell price levels. For quote-driven trading, operators must provide the best offers and bids in real time. After-trade transparency requires financial market players to make available the volume, price and execution time of all orders relating to listed shares. Without a data warehouse environment that can automatically scan and aggregate thousands or millions of orders in real time, fulfilling both pre- and after-trade requirement would require enormous human resources.
- Commitment to best order execution – Financial services firms must expend reasonable effort in ensuring that every client order is executed in the best interests of their client. To do this, such firms would naturally need a sophisticated data warehouse that makes it easy to appraise every order for speed, price and other factors that would come into play in determining whether the eventual execution is what was best for the client.
MiFID II pushing data warehouse requirements even further
Based on discussions that have been ongoing from early 2011, many analysts expect MiFID II to institute new transparency requirements especially targeting derivatives that will surpass the 2004 directive. This will automatically translate to an even larger amount of data that financial and investment services companies will be directly responsible for. More stringent risk management regulations will also demand that banks record, manage and make available in real time every financial transaction. Such data will make it easier for both management and financial services regulators to determine the risk exposure of the institution (and by extension its clients) at any point in time.
This massive real time data computation and storage demand will inevitably have a major impact on the data warehouse infrastructure of most European financial services providers. In fact, several critics of some MiFID II proposals are already citing the technical infrastructure required to actualize the directives and regulations as too expensive to implement for a smaller and medium-sized market players.
Yet, without appropriate investment in the right data warehouse hardware and software, even seemingly minor errors and downtime can cause non-compliance that can bring a financial firm’s operations to a grinding halt. Financial services providers will have to go for powerful data warehouse platforms that have demonstrated resilience in the face of demanding, high volume, real time data analysis and reporting.
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