US embassy cable - 03FRANKFURT8965

UNCLAS SECTION 01 OF 04 FRANKFURT 008965 
 
SIPDIS 
 
STATE FOR EUR PDAS RIES, EB, EUR/AGS, AND EUR/ERA 
STATE PASS FEDERAL RESERVE BOARD 
STATE PASS NSC 
TREASURY FOR DAS SOBEL 
TREASURY ALSO FOR ICN COX, STUART 
PARIS ALSO FOR OECD 
TREASURY FOR OCC RUTLEDGE, MCMAHON 
 
E.O. 12958: N/A 
TAGS: ECON, EFIN, EUN 
SUBJECT: Investment Services Directive:  Ruffled Feathers 
and Deja vu All Over Again 
 
Ref: (A) Frankfurt 7111; (B) Rome 4730 
 
T-IA-F-03-0057 
 
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 
winners." 
 
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 
t 
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 
winners." 
 
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 
officials. 
 
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 
e 
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 
wallarjg2@state.gov; tel. 49-(69)-7535-2431, fax 49-(69)- 
7535-2238. 
 
BODDE