The European securi-ties industry is sailing into uncharted waters after a sweeping new rule that is expected to affect all securities firms in the region took effect on Nov. 1.

The Markets in Financial In-stru-ments Directive (MiFID), represents a major reform of European securities rules. It comes as part of a larger effort by the European Commission to create a single market for securities products in Europe, largely through a passport model that’s similar to the provincial initiative being implemented in Canada.

MiFID expands on an earlier regulatory directive by broadening the roster of products and services — including investment advice, various derivatives and trading services such as internalized and alternative trading systems — that can be offered across borders under the passport.

It also intensifies efforts at investor protection by setting out more detailed conduct requirements and improving transparency via pre- and post-trade reporting and best-execution requirements for both exchanges and over-the-counter trades. Additionally, it imposes capital requirements for many firms, and aims to correct some of the technical issues that arose with previous versions of the passport regime.

The hope is that the changes will lead to more competition and deeper markets as firms that are already active in one European country expand their operations into other jurisdictions covered by the new regime. Foreign firms are also expected to be enticed to enter the market by the prospect of dealing with the entire European market, not just the country in which they set up shop.

The new rule is also expected to have a significant effect on financial services firms doing business in the region, including investment banks, portfolio managers, broker/dealers and other financial services firms. It means that, for the first time, financial advice will be regulated throughout Europe.

Also, the trading business is expected to see some of the most significant changes, as firms will be able to route trades to many trading venues, not just the local exchange.

It will take some time for all of the effects of MiFID to become clear, but firms are gearing up to capitalize on the opportunity. For example, the planned changes to the trading regime sparked the creation of Project Turquoise, a dealer-founded trading system being set up by a group of firms — Citigroup, Goldman Sachs Group Inc., Deutsche Bank AG, Merrill Lynch & Co. Ltd., UBS AG, Morgan Stanley and Credit Suisse Group.

That effort, in turn, has inspired Canadian firms to pursue their own version of an alternative trading system, known as Project Alpha, to compete in the similarly evolving domestic trading landscape.

The prospect of operating in a more open, competitive European trading market is being cited as one reason Nasdaq Stock Market Inc. is moving to buy OMX AB, which is based in Sweden. “Since OMX is a relatively small exchange in Europe, [Nasdaq] will most likely focus on taking market share from the larger European exchanges rather than defending its own market share,” notes a report by Sandler O’Neill + Partners LP, a New York-based investment bank specializing in the financial services industry.

Had Nasdaq been successful in its effort to buy the London Stock Exchange PLC, it probably would have found itself trying to protect its market share rather than grow it. “If Nasdaq had acquired the London Stock Exchange, [Nasdaq CEO Bob] Greifeld commented it would likely adopt a defensive strategy in a post-MiFID Europe to protect the LSE’s share of listings and transactions,” the report adds.

Another prospective beneficiary of the new regime is the various ATSes that are clamouring for volume around the world. As trading gets increasingly fragmented — in response to the new best-execution requirements and other MiFID rule changes — ATSes are expected to thrive. Indeed, Sandler O’Neill notes that trading firms such as Investment Technology Group Inc. and Liquidnet believe they are poised to capitalize on the new post-MiFID environment.

Similarly, a report by Deutsche Bank Securities Inc. indicates that ITG’s management sees its greatest opportunity in Europe “as the MiFID directive helps European markets move toward a U.S. model, in which alternative trading venues can take business from established exchanges by better serving niche trading constituencies.

“Algorithmic trading and off-exchange trading is still in early stages in Europe,” continues the report, “and management sees a great opportunity to expand its business in Europe, as MiFID is expected to cause the European markets to fragment. The hope is that the European business can thrive as the U.S. business did in the late ’90s, when [electronic communications networks] saw strong growth and market share gains from established exchanges (as well as increasing margins).”

@page_break@Between the development of Project Turquoise, the increasing opportunities for the ATSes and the prospect for more internalization, the traditional stock exchanges are expected to experience pressure on their market share. That could mean competitive responses by the exchanges, such as price cuts and more aggressive technology investments, as they defend their turf.

Although a number of firms see opportunities to seize market share in the trading business, not everyone expects the exchanges to be seriously threatened by new competitors. New York-based investment bank Keefe Bruyette & Woods Ltd. suggests that stricter trading disclosure rules may deter internalization. It sees ATSes as a more serious competitive threat, particularly the one being set up by the consortium of investment banks, Project Turquoise.

“Nevertheless, we believe the new entrants will have their work cut out to take market share from the incumbents,” the Keefe Bruyette report says. “Liquidity remains the biggest barrier to entry, and the tricky subject of post-trade services in clearing and settlement provides further defence for the incumbents. Liquidity shift events are few and far between, and usually associated with the new entrant having a clear technological advantage rather than pricing.”

Keefe Bruyette expects pricing pressure to be the real impact.

Equities aren’t the only area of the business that will be touched by MiFID. The derivatives business is also likely to be affected significantly as it is brought under the passport regime for the first time. “The rule change has the potential to alter the relationships among brokers and exchanges and the OTC markets,” notes Sandler O’Neill in a report on MF Global Ltd. , a derivatives broker. It says that MF Global believes the new rules will encourage brokers to internalize more trades.

However, Sandler O’Neill is cautious about forecasting the effects of the new regime. “In general, we believe the effects of rule changes are difficult to predict,” it says, “and we believe the specific effects of MiFID on internalization will only become clear over the coming quarters and years.”

Nevertheless, the pressures are also expected to flow through to brokerage firms. Connecticut-based research firm Greenwich Associates Inc. notes that MiFID may make it harder for small and mid-sized brokerage firms to thrive.

Along with more scope for trading competition, Greenwich says, MiFID should make it “easier for global brokers and large pan-European firms to compete with country and regional brokers at the local level.”

Trade reporting is another area that’s expected to be up for grabs in the post-MiFID environment. Keefe Bruyette predicts that new market entrants will be more successful in taking share in this business than they will in trading itself.

Here again, a consortium of investment banks is setting up a prime contender for this business. The seven firms that are behind Project Turquoise, along with ABN Amro Bank NV and HSBC Group, are backing a venture known as Project BOAT. This initiative (also known as Markit BOAT, as Markit Group Ltd. has been hired to run it) is designed to capitalize on new trade-reporting and best-execution requirements for OTC trades that are being introduced as part of MiFID.

Although this last initiative may be a front-runner to capitalize on the new rules in the trade-reporting arena, Keefe Bruyette suggests, there may be room for plenty of competition in the area.

“The barriers to entry appear low, with the product highly commoditized,” says the Keefe Bruyette report. “We do not believe trade reporting, once stripped of its regulatory protection, has the natural monopoly characteristics of trade execution.”

Already, the competition is heating up. In mid-October, BOAT announced that it will offer its real-time data free until Jan. 1 and, once it begins charging for real-time data, it will begin offering a delayed data feed for free. Additionally, both Deutsche Borse Group and Instinet LLC’s Chi-X Europe Ltd. trading system have announced that their OTC trade-reporting services have been approved for operation by Britain’s Financial Services Authority.

Whenever sweeping regulatory change occurs, it takes time for the effects to become clear. There are unintended consequences and innovative developments that lead the industry down unforeseen paths. Nevertheless, the fallout should be interesting to watch.

It may also be particularly instructive for Canadian regulators, due to the fact that MiFID addres-ses many of the issues with which they are wrestling, such as structural problems, creating a single market across multiple jurisdictions, content issues, imposing best-execution requirements, regulating advice and dealing with novel products. IE