Cablegate: Investment Services Directive: Ruffled Feathers

This record is a partial extract of the original cable. The full text of the original cable is not available.




E.O. 12958: N/A
SUBJECT: Investment Services Directive: Ruffled Feathers
and Deja vu All Over Again

Ref: (A) Frankfurt 7111; (B) Rome 4730


1. (SBU) Summary: The political agreement reached by EU
Finance Ministers on the Investment Services Directive (ISD)
on October 7 ruffled more than a few feathers. The UK is
upset with the Italians who pushed through a position over
the British objections; the European Commission is upset
with the Brits; a MEP is upset with the Council and the
Brits; and investment firms are frustrated. Those
apparently unruffled are stock exchanges outside the UK and
Commissioner Fritz Bolkestein who crowed: "Europe, its
financial markets, investors and citizens will all be

2. (SBU) The issue was a "pre-trade transparency" provision
for investment banks. Such a requirement would force them
to act like stock exchanges and entail new costs. The
"compromise" that emerged from the Council meeting was
passed over the objection of five member states - something
that is simply not done if at all avoidable. Commission
officials would like to broker a further compromise in the
reconciliation of the Council's text with that passed by the
Parliament. So the issue is still alive, but faces
significant challenges.

3. (SBU) Moreover, any compromise that splits the difference
between policy views might lose sight of the objective to
create an efficient EU capital market. This would be a
pity. Moreover, the process will not be transparent -
running the risk of another disappointment of an unworkable
text. Recall that a year ago the controversial provision
was inserted at the level of the Commissioners after the
text had been informally vetted and praised by investment
firms. The Parliament's text reflected a compromise text
supported by investment firms and stock exchanges, but was
ignored by the Council. Dj vu, all over again.

Nobody is Happy, but Everyone Will be Winners

4. (SBU) At the October 7 Ecofin, Finance Ministers grappled
with the remaining political issues in the ISD. This
directive is to update the existing EU rules for the
operation of stock exchanges and other trading venues, such
as multilateral trading facilities (electronic exchanges)
and investment firms that "internalize" trades by matching
buy and sell orders "in house." One of the key issues was
pre-trade transparency. Investment firms had argued that
since they are subject to conduct of business and "best
execution" rules, they had no need to publish prices in
advance of trading. To do so would be costly and force them
to operate as stock exchanges. The UK supported this line.
Internalization is a prevalent practice in London.

5. (SBU) France and Italy, among others, supported pre-trade
transparency for investor protection - and to create a
"level playing for stock exchanges." At present, these
countries have "concentration rules," requiring all trades
to be executed on their stock exchanges. Internalization is
not permitted.

6. (SBU) The compromise text forged in Ecofin would require
pre-trade transparency for all but large (so-called "block")
trades. Moreover, once a price were published, the firm
would have to honor that price for retail customers, but
could offer price improvement for professional traders.
This would make investment firms operate even more like
stock exchanges, driving up costs and widening spreads
between bid and ask prices as they would have to deal with
clients with which they have no relationship -and their
credit risks.

7. (SBU) Reaching the compromise was not a happy moment for
some. The compromise was passed without the approval of the
UK, Ireland, Sweden, Finland and Luxembourg. According to
Commission officials, forcing through a major issue over the
objections of a member state that has a strong interest in
an issue is very unusual. The UK was not happy that the
Italians pushed the issue through without vetting possible
texts in advance; bloodied but not bowed, the Brits were
happy they held their ground.

8. (SBU) Commission officials berate the UK delegation for
not engaging in negotiations of a compromise. "The most
unbelievable negotiations I have ever seen in my life,"
charged one. Commission officials are also not pleased that
the Italians were so forceful in overriding the UK position.
"There will be consequences," one darkly predicted.

9. (SBU) The Italians are pleased that they delivered a
political agreement on the ISD, one of their top priorities
of their EU Presidency. One Italian Finance Ministry
official downplayed the dust up. Investment firms are
greedy, in his view (spoken with some authority having
worked for one himself).

10. (SBU) The Member of European Parliament who managed the
legislation for the Parliament had worked hard to forge a
compromise that gained a majority vote of the Economic and
Monetary Affairs Committee and the plenary and won the
backing (grudgingly) of investment banks and stock
exchanges. That text would have (a) imposed a pre-trade
transparency obligation to a narrower range of trades; (b)
permitted price improvements from the published quotes; and
(c) allowed investment firms to select the clients with
which they would deal. This text, however, did not figure
in the Italian proposals in Council.

11. (SBU) Another MEP lambasted the UK negotiating tactics.
Some investment firms who had worked on the Parliament text
are frustrated. Deutsche Boerse publicly praised the
outcome, but privately admitted that the text was unclear.

12. (SBU) Commissioner Fritz Bolkestein was clearly pleased.
After all, the revision to the ISD is was much bigger than
just one article, covering many important and difficult
issues. In the Commission's press release, Bolkestein is
quoted as saying: "The Directive will make it easier for
businesses to raise money, improve investor confidence and
promote growth. The only losers will be those who want to
hide behind national barriers to stifle competition and
short change issuers and investors. If we can get this
Directive through on time, as I think we will, Europe, its
financial markets, investors and citizens will all be

Next Steps: Reconciliation

13. (SBU) DG Internal Market officials have said that they
want to try to find a consensus on the pre-trade
transparency issue. The timing for this will be early next
year. In December, the Council will transmit its common
position on the ISD to the Parliament. The Parliament will
have three months to respond. Early February would be the
time to try to forge a better outcome, according to these

14. (SBU) This is easier said than done. While wordsmithing
might be possible, to get a new text passed by Parliament
will require an absolute majority vote by all
Parliamentarians - 316 in favor. As the earlier text had
passed by only a small margin, this could be difficult.
Should the Parliament fail to muster enough votes, the text
would remain as agreed by the Council. The other option
would be for Parliament to vote down the entire proposed
revision to the ISD.

The Heart of the Matter: Efficient Markets

15. (SBU) The objective of the EU's Financial Services
Action Plan (FSAP) is to further integrate EU financial
markets. Each European national market has developed its
own system. As noted above, internalization is prevalent in
the UK. Channeling all sales through a stock exchanges is
common on the continent. The Commission's stated objective
in the ISD is to regulate trade execution venues without
stifling the competition between them. The Commission
acknowledged that the "one size fits all approach" won't
work. Let the market sort it out.

16. (SBU) The proposed revision to the ISD would lift the
concentration rules on the continent, so all trades would
not have to be channeled to stock exchanges. Rather, the
investor could chose whether to use a dealer that trades on
an exchange or one that deals on the basis of its own in-
house trading book. Member States agreed. The question
then became on what conditions internalization would be
permitted. It was here where the compromise was struck in
the Council.
17. (SBU) This, however, comes back to the question the
Commission couldn't answer, finding one approach to fit all.
A concern is that by restricting or increasing the costs of
London operations, investors would lose as higher costs are
pushed on to them. Liberalizing restrictions on the
continent could induce more competition. However, it is
questionable whether firms would make the necessary
investment to exploit this opportunity that is unfamiliar to
their market place. So it is not clear that merely reaching
an average between the most liberal and the most restrictive
markets is a good outcome for market efficiency. Again,
letting the market sort it out could be a better approach.

18. (SBU) One Commission official asserted that the
compromise is a middle course, between liberal rules of
London and more restrictive rules of the US. According to a
former SEC official working for an investment bank, this
characterization is not quite accurate. SEC rules do
require pre-trade transparency. However, the US reporting
system that publishes such quotes, the Intermarket Trading
System, took years to build, surrounding by detailed
regulations. No such system exists in the EU. Moreover,
under US rules, price improvement is possible. Quotes
signify a starting point for negotiations, like the sticker
price for a new car.

Consultations, Transparency and Workability: Dj vu

19. (SBU) Whether the compromise is right or not for
fostering greater efficiency for EU capital markets, the
other question is whether it is workable. A year ago the
Commission staff had consulted with the industry and vetted
a draft text without a pre-trade transparency provision for
investment firms. At the college of Commissioners level,
however, such provisions were inserted. Not only were
investment firms upset with the process, they soberly
pointed out that the text was unworkable.

20. (SBU) Action shifted to the Parliament. The lead
manager for the legislation, being from the UK, was
sympathetic to the investment firms' case. Politically, she
recognized early on that a pre-trade transparency provision
would be needed to pass the Parliament. Investment banks,
realizing that had lost in their opposition to any pre-trade
transparency, worked with her to find an acceptable
compromise text, one that could be workable.

21. (SBU) The Italian Presidency, according to one source,
had not engaged in detailed discussions on pre-trade
transparency during the Council working groups. Rather,
they waited until just before the Ecofin meeting to discuss
the issue. According to several experts, including in the
Commission, the text, not surprisingly, is not technically
clear. According to one investment banker, it could be
interpreted either very strictly or very broadly.

22. (SBU) In the view of a market expert, the issue of pre-
trade transparency is a "matter of taste." Why not let the
customer decide? An investment banker mused that his bank
would continue to internalize, but it will be a matter of
cost, one that his firm could meet but smaller firms might
not. Investors would be the one to foot the bill in
increase costs and fewer investment choices.

23. (SBU) Consultations and transparency can help the public
"assume ownership" for the outcome. However, they can also
help get technical matters ironed out before they become
questions of legal interpretations. The Commission and
Parliament seem to have taken that lesson to heart. The
Council would be wise to do so as well, at least in the
upcoming reconciliation process.

24. (U) This cable coordinated with Embassies London, Rome,
and Berlin.

25. (U) POC: James Wallar, Treasury Representative, e-mail; tel. 49-(69)-7535-2431, fax 49-(69)-


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