15 May 2002

CEPS: ISD Review - A difficult balancing act

-
(Excerpt)
“The ongoing review of the Investment Services Directive (ISD), on which a second consultative paper was circulated, is facing a difficult balancing act between the interests of the markets and those of the intermediaries”, as Karel Lanoo argues.

The second consultative paper has already scaled down some options raised in the first, but problems remain, the most important being the extent and regulation of 'internalisation' of order flow by intermediaries versus order matching by markets. The Commission now proposes to abolish the concentration provision and allow systematic internalisation by brokers subject to key investor protection safeguards.

Contrary to some earlier indications, the European Commission will maintain the basic structure of the (existing) Investment Services Directive (ISD). It will not go for a radical overhaul, by which the directive would be split in one applicable for exchanges and another for investment firms, but for a systematic review. The second consultative paper demonstrates how difficult it is to distinguish between different order execution venues, something that is nowadays even more complex than at the time the first directive was negotiated. The question thus arises to what extent and on what grounds can regulation mandate trades to be executed on a regulated market.

The exchanges argue a strict definition of 'regulated markets' and mandatory concentration is needed on the grounds of investor protection and the competitiveness of European equity markets. Loosening concentration will reduce liquidity and increase spreads, thus making equity markets less attractive.

Internalisation of order flow comes at a price as well. When intermediaries systematically internalise large volumes of client order flow, key investor safeguards such as 'best execution', order handling of controls, conflict of interest management, transparency obligations should be rigorously enforced.

The Commission proposal thus risks to be rejected by both, the markets, this is the traditional exchanges, and the internalisers, this is the large brokerage houses.

A political debate on internalisation in the European Parliament for example will most likely lead to a request for a formal consent by the investor, an 'opt-out' from execution on the regulated market, which will increase the cost of retail orders.

The European Commission will have a hard time to meet this schedule (to publish a proposal by end year 2002), in view of these strongly conflicting views. The 2005 target of the Financial Services Action Plan (FSAP) will surely be difficult to meet, certainly if the European Commission comes up with a proposal along the lines of the second consultative paper. In that case, it can be expected that the European Parliament will be intensively lobbied by the different interested parties, and thus a long decision process could be expected.

ISD Review - A difficult balancing act

© CEPS - Centre for European Policy Studies