New Laws for the Old Country

In the time-honored tradition of college students everywhere, the European Parliament is scrambling to meet a deadline. The chamber breaks for elections in May, and with “euroskeptic” parties polling well, legislators are keen to pass as much as possible while the pro-euro crowd has a strong majority. As a result, a lot of long-awaited legislation passed this week, including a host of measures impacting Europe’s capital markets and the investment universe. Most of these aren’t front-page news, but their implications are important for anyone investing in Europe, now or in the future.

One such measure contains rules and guidelines on high-frequency trading (HFT), with the goal of preventing “disorderly” market behavior. For example, HFT algorithms now need regulatory approval and must pass tests to ensure they “cannot create or contribute to disorderly trading conditions.” Other rules include curbs to halt/constrain HFT if there are “sudden unexpected price movements” and standardizing tick size to enable “reasonably stable prices,” while allowing bid-ask spreads to continue narrowing. HFT firms who keep open buy and sell orders will have to run their algorithms for a set number of hours each day—effectively formalizing their formerly defacto role as market makers, and the law encourages rejiggering exchange fees to promote transparency and stability, including permitting exchanges to adjust fees for cancelled orders (or for firms with high ratios of cancelled to executed orders).

While it’s encouraging that lawmakers acknowledge some of HFT’s benefits, like narrower spreads, market-making and greater liquidity, some of the rules rest on the premise that HFT causes big market moves, a la the many claims HFT caused 2010’s “Flash Crash.” However, there is no evidence intraday volatility has increased materially since HFT proliferated—or that HFT caused the Flash Crash. Much more evidence exists a fat finger trade ... human error ... caused the wild hour or two that day. One could even argue HFT may help mitigate volatility! During the Flash Crash and last year’s Twitter crash, for example, algorithms kicked in when markets fell sharply. While some suggest they exacerbated volatility (focusing on the sell side only), it is equally as likely rapid-fire buy orders helping bid prices back up were initiated. Overall, liquidity—the ability to buy or sell readily when desired at easily discernible prices—is a good thing. The HFT curbs passed Tuesday might make markets take longer to recover from those blips.

Overall, however, the rules seem benign enough, even if the legislation is a solution in search of a problem. They also don’t take effect for two-and-a-half years after member-state governments sign off, giving firms and investors have plenty of time to adapt to the new rules.

Parliament also moved the long-awaited EU banking union one step closer to reality, passing the Single Resolution Mechanism—the EU-wide system for closing/restructuring insolvent banks, which forces large depositors and creditors to take losses when banks go under. Those bail-ins aren’t great (as anyone impacted by Cyprus’s bank bail-ins last year will attest), but the system does have some positives. One, it further cements the euro, underscoring the currency’s long-term viability. Two, measures like the €55 billion deposit guarantee fund should help shore up investor confidence.

However, key questions and potential unintended consequences remain. One emerged earlier this month, when UK officials discovered that a bank using Emergency Liquidity Assistance (ELA) could trigger “resolution” procedures—allowing the ECB to close a bank simply for receiving state-guaranteed central bank assistance. Effectively, this could rob central banks of one of their primary functions: serving as lender of last resort. This defies 100 years of central bank history. ELA, in principle, exists to prevent banks from going under from short-term funding issues and to guard against bank runs. The BoE used ELA for this purpose throughout late 2008, and it’s widely credited with helping contain the crisis in the UK. Without it, RBS might very well have gone the way of WaMu.

The UK pushed for a rewrite, but the Netherlands, Finland and the Czech Republic rejected the UK’s request to exempt ELA, arguing reopening negotiations at such a late stage would put the whole banking union in jeopardy. However, the UK could still use its veto, as member-state governments have to approve the final rule. If the rule does survive in its present form, it likely isn’t a near-term risk, as EU Financials are improving overall. But it could have big implications during future crises, whenever those may be—something to bear in mind.

Rounding out the marathon, Parliament passed stricter restrictions on fund manager compensation. Though outright bonus caps fell on the cutting room floor, at least 40% of variable pay (i.e., bonuses) must be deferred for at least three years, and at least 50% of that pay must be awarded as shares of the actual fund—in other words, fund managers have to eat their own cooking. Lawmakers believe this will discourage excessive risk-taking, and maybe it will—incentives matter! But that won’t necessarily improve financial stability—regulators’ other intent. They passed the law with visions of 2008 dancing through their heads, but so-called risky fund management didn’t cause the panic. The rules also come with big compliance costs—proving you’re behaving will take a lot more paperwork, time, hassle and ultimately money. That may drive some fund managers away from the business. This could hurt competition and decreases options for European investors.

Other rules passed include the HFT rules’ parent law, the Markets in Financial Instrument Directive, which slaps new rules on a host of securities trading. Like Dodd-Frank in the US, it moves all commodities trading onto regulated exchanges—increasing transparency—but it also rests on a key fallacy: the notion more regulation makes markets less “crisis prone.” That meme underpins the lion’s share of financial rules passed this week, but it disregards history. Transparency is good, and increasing it is a noble objective. But often non-existent issues get “fixed” in the process, and that creates winners and losers over time. Even though the near-term impact of many of these rules is limited, for investors, it’s key to understand the new rules and how they could impact markets and investing options down the line.

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