18 February 2003

EMAC hearing on ISD

The Commission’s proposal to revise the Investment Services Directive with a view to achieving an integrated European financial market came under fire at a special hearing of experts organised by the Economic and Monetary Affairs Committee.

Representatives of the banking and investment community concentrated in their statements on their diverging views on the subjects of internalisation and pre-trade transparency. Concerns were also raised that the Directive would place unnecessary pressure on investment firms that only execute orders and do not provide any advice to customers, and could lead to execution-only firms being driven out of business. While there was general consensus on the need for a new approach, fears were expressed that an over-regulatory approach could put up the costs of share dealing and could quite possibly drive business offshore.

The problem is devising a set of rules to protect cross-border investors in European stock markets where there are considerable variances in national practices. While the UK market is essentially self-regulatory with private shareholders protected by the “best execution” principle, under which a broker is obliged to obtain the best price for his client, the situation is not necessarily the same in other EU states.

Transparency, internalisation, and fragmentation
One of the most debated points in the hearing was to what extent in-house stock trading should be subject to transparency requirements, and in how far this may lead to a fragmentation of markets.

A number of experts welcomed the new concepts, as they would increase competition and also increase the liquidity pool. Higher competition would therefore lead to better prices. A fragmentation, although only to a small extent, could probably happen, but the effects are not seen to be negative.

Other experts saw the danger that systematic internalisation may have an impact on the liquidity of markets. Mr Buchbauer, representing the European Savings Banks Group (ESBG), said that in bypassing the market price formation mechanism, internalisation systems import prices from the regulated markets as reference prices and withdraw liquidity for their exclusive internal use. Therefore, extensive internalisation could lead to a considerable reduction of price quality of European capital markets.

This liquidity crunch might have negative consequences for less liquid markets in Europe as for example in Spain or Austria. He also stated that the liquidity of the UK market is much higher than that of other European markets.

To balance this effect, the Commission has foreseen requirements to disclose information before trading. Although Mr Finkh, from Allianz Dresdner Asset Management, said that he cannot see any benefits from this pre-trade transparency obligation, many other experts regarded the transparency obligations, although expensive, as an important and necessary factor for price formation processes.

Mr Pinatton, Chairman of the French Association of Investment Firms (AFEI), stressed that investor confidence is inextricably linked to a high level of market transparency and that the market is made for investors and not for intermediaries. He added that best execution obligations are no substitute for transparency.

Execution-only services
Many speakers at the hearing were concerned about the Commission's proposal to make all investment firms subject to a “suitability test”.

Mr Buchbauer pointed out the problem of introducing a suitability test for execution only services. Clients often do not want these tests and in some cases, such as online brokerage systems, these tests do not make sense. Mr de las Cuevas from the European Association of Securities Dealers said that, with regard to the enormous costs involved, this could probably mean the end of the execution-only sector of the stockbroking industry.

Reflecting on the experience of the UK market Ms Hay, representative of ProShare, said that execution only business is quite common in the UK. The introduction of a suitability test is not necessary as private investors are very content with this procedure and claims are negligibly low.

The rapporteur of the European Parliament, Ms Villiers, aims to complete the first draft of her report on the Directive by 19 February.

The Position Papers of the experts can be downloaded from the EMAC website.

© Graham Bishop