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

UNCLAS SECTION 01 OF 04 FRANKFURT 007111 
 
SIPDIS 
 
SENSITIVE 
 
STATE FOR EUR PDAS RIES, EB BAY, EUR/AGS, AND EUR/ERA 
STATE PASS FEDERAL RESERVE BOARD 
STATE PASS NSC FOR CLOUD 
TREASURY FOR DAS SOBEL 
TREASURY ALSO FOR IMI HARLOW, AUSTIN 
PARIS ALSO FOR OECD 
TREASURY FOR OCC RUTLEDGE, MCMAHON 
 
E.O. 12958: N/A 
TAGS: ECON EFIN EUN
SUBJECT: Investment Services Directive Moving Toward 
Compromise 
 
T-IA-F-03-0043 
 
This cable is sensitive but unclassified.  Not/not for 
Internet distribution. 
 
Ref: (A) 02 Frankfurt  11356 ; (B) Frankfurt 2629; (C) USEU 
2629 
 
  ¶1.   (SBU) Summary:  Negotiations on the controversial pre- 
     trade transparency provisions of the proposed revision to 
     the Investment Services Directive appear to be moving toward 
     a compromise. Compromise amendments circulated in the 
     European Parliament and texts being discussed in the Council 
     Working Group point in a similar direction: to maintain pre- 
     trade transparency, but make the provisions more workable 
     for investment firms.  Investment bankers, recognizing they 
     have lost the battle for deleting any pre-trade transparency 
     requirements, hope and pray the compromise texts will be 
     accepted.  Nothing is certain. 
 
  ¶2.   (SBU) The fact that the Italians and the Dutch, both 
     reportedly having favored a strong pre-trade transparency 
     text, now have drafted compromise language gives reason for 
     optimism that the directive can be finalized in the next few 
     months.  Their new position doesn't necessarily represent a 
     change of heart, but rather a change of point of view.  The 
     Italians now have the EU Presidency, meaning they now have 
     the lead on ISD drafting and have pledged to get it done. 
     The Dutch position is driven by the Finance Ministry, 
     according to an investment banker, which takes a different 
     view of the issue than the securities regulators who had 
     shaped their earlier position. Thus, the text could be 
     finalized this fall. Given its history and the number of 
     technical issues, risks remain for slippage.  Notably, the 
     ECB has weighed in favoring pre-trade transparency not only 
     for shares, but also debt instruments.  While one bond 
     expert regards the ECB position as out of touch, a Brussels 
     lobbyist reports that the Italians are willing to consider 
     such an extension.  End Summary 
 
Pre-Trade Transparency in the ISD: Questions with No Clear 
Answers 
--------------------------------------------- -------------- 
 
  ¶3.   (SBU) The London Investment Bankers Association (LIBA) 
     and the US Securities Industry Association (SIA), 
     representing European and US investment firms, were sorely 
     displeased when the European Commission modified its 
     proposal for revising the ISD at the last minute by 
     including a requirement for these firms to provide pre-trade 
     transparency (ref A).  They had argued that publishing 
     prices before executing a trade provides little information 
     to the market place not captured by post-trade reporting. 
     Investors would be protected from being fleeced by 
     subjecting investment firms to "best execution" obligations. 
     Moreover, pre-trade transparency could drive market prices 
     down, resulting in lower prices for investors.  Such 
     requirement would also require changes to the way investment 
     firms do business, requiring investment in new mechanisms. 
     All arguments that Commission staff had accepted, but the 
     Commissioners did not. 
 
  ¶4.   (SBU) Investment firms took a hard line position that 
     the pre-trade transparency provisions were unworkable and 
     should be deleted.  The lead manager for the legislation in 
     the European Parliament, Theresa Villiers took a similar 
     view in her initial report on the ISD (ref B).  In her view, 
     the best solution would be to drop the offending article. 
     Privately, however, she knew that a compromise would be 
     necessary. 
 
  ¶5.   (SBU) Investment firms complained about the details of 
     the proposed pre-trade transparency requirements.  Under the 
     Commission's proposal, investment firms are to "make public" 
     a "firm bid and offer price" for transactions of a "size 
     customarily undertaken by a retail investor" and to trade 
     with "other investment firms and eligible counter parties at 
     the advertised prices."  How were they to make such 
     information public?  Would a firm price mean that they would 
     not be able to offer price improvements, even as market 
     conditions changed? What is a transaction size that is 
     customary for retail investors?  Forcing investment firms to 
     deal with all potential investors, regardless of their 
     credit rating or relationship with the firm, could subject 
     them to higher credit risks.  Too many questions with no 
     clear answers.  Some investment bankers had the distinct 
     feeling that these provisions were designed to increase 
     costs to investment firms and deprive them of their 
     competitive advantage over stock exchanges. 
 
Compromise Possibilities:  Italians and Dutch Try Their 
Hands 
--------------------------------------------- -------------- 
 
  ¶6.   (SBU) At the end of June and early July, the Dutch and 
     Italians took their hands at fashioning possible compromise 
     texts in the Council Working Group.  The role of both is 
     notable.  The Dutch financial market regulator had 
     criticized "internalization," e.g. where an investment firm 
     can match trades in-house.  Italian interests reportedly 
     were among those that had moved the College of Commissioners 
     to adopt a pre-trade transparency requirement last November. 
     According to one investment banker, the Dutch position has 
     shifted as the Finance Ministry has taken the lead on the 
     issue and has a different view.  The Italians, now in the 
     Presidency, feel the pressure to deliver results on the ISD. 
     The Italian Finance Minister has pledged that the ISD will 
     be completed under the Italian Presidency. 
 
  ¶7.   (SBU) The Dutch took the view that some transparency is 
     needed to benefit price formation but that competition 
     between different trade execution venues was also 
     beneficial.  To cover both points they proposed that the pre- 
     trade transparency obligation apply only to retail trade. 
     Pre-trade disclosure of large trades could result in the 
     market moving against the firm publishing the quote, a view 
     shared by investment firms, which could dry up market 
     liquidity. 
 
  ¶8.   (SBU) Further, the Dutch reasoned that only firms 
     active in the retail market that internalize would be 
     subject to pre-trade transparency requirements.  Such 
     "internalizers" would be defined as those who regularly 
     execute retail client orders in shares by dealing on its own 
     account.  Just trading in-house against a firm's propriety 
     book would not count as internalization.  A firm should also 
     be able to improve or change the price depending on market 
     conditions, in the Dutch view.  Finally, investment firms 
     should be able to control with whom they do business, e.g. 
     they would offer their services to their own retail clients 
     but not have to trade with all comers. 
 
  ¶9.   (SBU) These same points have been picked up in a 
     Council Working Group text drafted by the Italians based on 
     a Group meeting on July 7.  In this Italian version 
     investment firms are to publish firm prices for shares for 
     which they are "systematic internalizers," i.e. 
     systematically dealing on its own account in transactions of 
     a "standard size" of shares admitted to trading on a stock 
     exchange.  Such internalizers would be able to withdraw 
     prices in accordance with market conditions.  Prices and the 
     sizes of trades are to be made public in a manner that is 
     easily accessible to the firms' clients and to market 
     participants on a "reasonable commercial basis." Finally, 
     systematic internalizers would be allowed to decide, in a 
     non-discriminatory way, the persons they accept as clients. 
 
Parliament in Sync 
--------------------------------------------- -------------- 
 
  ¶10.  (SBU) Whether by coincidence or design, the compromise 
     amendments offered by Villiers on July 10 look very similar 
     to the new Italian text.  Investment firms which practice 
     systematic internalization are to publish firm "quotes" (not 
     prices) for transactions of a "standard market size" for 
     shares admitted to trading on a stock exchange.  Systematic 
     internalizers would have to deal with their "clients" at a 
     price equal to or better than the quote. Thus, they would 
     not have to trade with all comers and they could improve the 
     price based on market conditions.  Finally, the compromise 
     text would require the prices to be accessible to other 
     market participants on "reasonable commercial terms." 
 
Principle Established, A Question of Price 
--------------------------------------------- -------------- 
 
  ¶11.  (SBU) Investment firms experts are generally pleased 
     with the direction of these ideas.  Their preference still 
     is not to have any pre-trade transparency provision.  Not 
     winning the principle, their next objective is to make the 
     provisions as tolerable and as inexpensive as possible. 
 
  ¶12.  (SBU) Even if the compromises being discussed were to 
     be accepted, important details would remain to be 
     elaborated.  Both the Italian and Villiers text would have 
     the European Commission together with the Committee of 
     European Securities Regulators (CESR) specify the size of a 
     transaction that would constitute a "standard market size," 
     in implementing measures.  A standard market size could vary 
     from market to market.  Thus, the scope of the provision 
     will remain unknown until such measures are adopted. 
 
Chance for Success? 
--------------------------------------------- ---------- 
 
  ¶13.  (SBU) According to a representative of an investment 
     firm, the Villiers and Italian text have a chance of being 
     adopted.  The Villiers text is scheduled to be voted on in 
     the Economic and Monetary Affairs Committee on September 10. 
     The compromise text is to be the basis for that vote. 
     However, according to this representative, EMAC members 
     agreed to vote as long as all respected a "cease fire" 
     during the summer recess not to seek changes to the text. 
 
  ¶14.  (SBU) Whether the Italians can pull their text through 
     the Council Working Group is also unknown at this point. 
     The Italians, however, have been working on the text in 
     August - but the August vacation period has slowed their own 
     internal efforts.  European Parliament staffers have pointed 
     out that if the Council does not send a text to EMAC by 
     November, legislative mechanics alone could preclude final 
     adoption of the directive before the Parliament's scheduled 
     April adjournment. 
 
European Central Bank Takes A Hand:  Nave or Just Out of 
the Picture? 
--------------------------------------------- ------------ 
 
  ¶15.  (SBU) On June 12 the European Central Bank (ECB) issued 
     an opinion on the proposed revision of the ISD.  The ECB 
     "welcomed" the Commission's proposed rules on pre-trade 
     transparency as "advancing the fundamental goal of allowing 
     investors to choose the more efficient trading venues."  The 
     ECB also opined that there is a "strong case for 
     consolidating price information at the EU or euro area 
     level" and thought that public authorities could "act as 
     catalysts" to the private sector to undertake such an 
     effort. 
 
  ¶16.  (SBU) The ECB goes on to criticize the Commission's 
     proposal for limiting transparency to shares.  Rather, the 
     ECB "recommends that the Commission reconsiders the scope of 
     the transparency rules and extends them to debt securities." 
     If it is not possible to do so, then the Commission should 
     report in two years on the possibility to extend the 
     provisions to debt securities, rather than in four years as 
     provided in the Commission's initial proposal. 
 
  ¶17.  (SBU) The "Financial Services Newsletter" of Brussels- 
     based Houston Consulting reports that the Italian Presidency 
     is will to consider the extension of the Article 25 
     reporting requirement to bond.  The Italian July draft, 
     however, does not extend pre-trade transparency provisions 
     to debt instruments, but does incorporate the idea of a 
     Commission report in two rather than four years. 
  ¶18.  (SBU) According to several bond experts, the notion of 
     transparency in debt security prices is rather unique. They 
     point out that the bond market is composed of many bonds 
     that have many different features and are much more 
     heterogeneous than equities.  Thus, comparisons between bond 
     prices are very difficult.  Moreover, once bonds are placed, 
     generally they are not traded but held by investors. 
     Accordingly, these experts note that the market for a 
     specific bond may not be very liquid after the initial 
     placement.  One bond expert believed that the ECB was rather 
     nave in its approach.  Pre-trade transparency for bonds 
     sounds fine in theory, but in practice irrelevant, in his 
     view. 
 
 
  ¶19.  This cable coordinated with Embassies Berlin, Rome, The 
     Hague and USEU Brussels. 
 
  (U)     POC: James Wallar, Treasury Representative, e- 
     mail wallarjg2@state.gov; tel. 49-(69)-7535-2431, fax 
     49-(69)-7535-2238. 
 
Bodde