New European regulation will have unintended consequences for emerging markets

Anne Clayton, Head: Public Policy, Johannesburg Stock Exchange (JSE) takes us through the potential consequences of regulation such as MiFIR and MiFID II on emerging exchanges.

Effective regulation is a crucial element for instilling confidence in the functioning of stock exchanges as well as the broader financial markets system.

To achieve this, the manner in which financial markets are regulated must constantly evolve, and exchanges have to ensure that they keep abreast of how new developments, both in their own and also foreign jurisdictions, will affect them.

This can be challenging for smaller and emerging exchanges, which may have limited resources and are consequently unable to continually scan the regulatory horizon. The focus of those that can devote resources to the monitoring of regulatory developments is usually on domestic regulatory requirements, while those that do try to keep up with international trends unfortunately lack the necessary expertise to do so effectively. A relevant example of such being the absence of sufficient exposure to European or American law, to enable them to develop their own policy positions, without incurring the cost of foreign legal counsel.

The result is that the regulatory requirements of large and developed financial markets could have a significant impact on small and emerging exchanges and this is easily overlooked. The EU Markets and Financial Instruments Regulation (MiFIR) is a particularly relevant example. European financial market participants are themselves still coming to grips with how MiFIR and its related directive (MiFID II) will affect them, but it appears that little consideration has been given to the unintended consequences these regulations will have for emerging third country exchanges.

When MiFIR comes into effect in January 2018, EU investment firms will only be permitted to trade shares (that are already admitted to trading on an EU regulated market or traded on a EU trading venue) on a regulated market, a multilateral trading facility (MTF) or Systematic Internaliser (SI), or a third country trading venue that has been assessed to be equivalent to an EU regulated market.

This will mean that, even if the deepest pool of liquidity is on a third country exchange, should a third country exchange not be deemed to be equivalent to an EU regulated market, EU investment firms would be unable to trade on the third country exchange, and would instead be required to trade dual listed shares on an EU regulated market, MTF or SI.

This has obvious consequences for the liquidity of dual listed shares on emerging exchanges, but the trading activities of MTFs could result in the impact on these exchanges being even more profound. MTFs are able to make any shares available for trading without the approval of their issuers. Some 150 South African shares are already available for trading on an MTF in Europe. Other MTFs could make shares listed on emerging market exchanges available for trading at any time, and are likely to, if the regulatory impact of MiFIR/MiFID II provides a business opportunity to do so.

Relatively low levels of liquidity is one of the biggest challenges emerging exchanges face and they often rely heavily on foreign activity in their markets. Any policy that could shift liquidity away from emerging exchanges will have a detrimental impact on their development.

It may seem that attaining EU equivalence is an obvious remedy that would easily address this issue, but the process for attaining EU equivalence is complex. It requires a third country exchange to reach out, through its local competent authority, to a competent authority in an EU member state that is prepared to act as sponsor for that exchange. A number of markets are currently being assessed for equivalence by the European Commission, assisted by the Expert Group of the European Securities Committee, which places emerging exchanges at a disadvantage, as the larger global exchanges will take priority and it is unclear whether emerging exchanges will be afforded the opportunity to be assessed for equivalence (assuming the exchange meets the minimum conditions) by the time that MiFIR and MiFID II comes into effect.

The volume and complexity of financial market regulation is such that unintended consequences are not always obvious or easy to identify. This is where organisations like the World Federation of Exchanges (WFE) can assist. In fact, the WFE has recently commenced an initiative to engage with appropriate authorities and identify and share, with its membership, summaries of regulations that have an extra-territorial reach or in which equivalence or recognition is required by an exchange in another jurisdiction. Through the sharing of this information, emerging exchanges are more likely to recognise the unintended consequences of these policies early enough to enable them to react and develop collective or individual advocacy positions, where necessary.