Many in Europe’s financial industry have mixed feelings about the new regulations that will take effect on November 1, 2007. The Markets in Financial Instruments Directive (MiFID) will inject Anglo-Saxon standards of transparency and disclosure into European investment advisory services and securities trading. It will force firms to change fundamentally the way they conduct business.

By reducing the regulatory differences among the European Union’s 27 national markets, the new regime should—in the long run—cut costs, increase efficiency, and stimulate growth. MiFID will also tilt the balance in the marketplace in favor of customers.

In the short run, however, bankers and asset managers will be forced to work harder, perhaps for smaller profits. Even by EU standards, MiFID is complex, affecting virtually every aspect of an investment firm’s business. According to several recent surveys, more than half of the affected companies will not be ready by the November 1 deadline. Our experience with clients bears this out. Those that adapt to the new rules quickly will therefore have a chance to establish a “first-mover advantage.” Those that fail to do so will find themselves punished, if not by regulators then by market forces.

MiFID’s impact will be most pronounced on the Continent because UK regulations are already much closer to the new standards. For example, the current British “Know Your Customer” requirements, which try to ensure that advisers understand the needs and risk tolerance of customers, are much closer to the MiFID standard than, say, regulations in Italy. Some countries, notably France, Greece, Italy, and Spain, will be forced to abandon such restrictions as “concentration rules.” These rules require stock transactions to be executed on regulated exchanges only. MiFID will make it possible to conduct European-wide stock transactions on unregulated trading venues as well, which is already allowed in some countries, including the United Kingdom.

MiFID’s investor protection rules will increase the pressure on financial firms in two important ways.

First, the “suitability test” will require firms to classify clients into three different categories: professionals, retail clients, and “eligible counterparties” (for instance, large investment banks). Firms will then have to apply the “Know Your Customer” test, which can be very time consuming and expensive. Interviewing retail clients for 45 minutes to establish their risk profile without any guarantee that they will make a small investment could become too costly for some players. We know of one Italian firm that is mulling whether to stop serving mass-market customers in cases where the suitability test would be required. Other firms could be tempted to advise their clients to invest in products not covered by MiFID—for example, life insurance or bank deposits. This move might be smart to avoid the regulatory burden, but it might not necessarily be in their clients’ best interest.

Second, MiFID will reform the so-called inducements, or kickbacks, that asset managers pay to a distributor, such as a bank, to sell their products. MiFID will require distributors to make these fee and commission arrangements much more transparent for the customer. This step will inevitably result in much fiercer price competition, particularly in private banking.

Some firms will try to reduce the MiFiD burden as much as possible, perhaps by creatively interpreting the rules. Others might continue with their current sales practices and simply add the MiFID requirements without trying to incorporate them more systematically. Such an approach, however, is likely to reduce efficiency. In an increasingly competitive market, a significant portion of investment-related profits will be at risk.

The alternative is to redesign the business strategy from scratch in light of the new regulatory requirements. MiFID compliance could then become a chance to improve customer relations through simplified investment products, streamlined sales processes, and the detailed risk profiles that the regulations demand. This means taking a hard look at what products are offered to which customers, how they are sold, and how back-office systems can be reconfigured to support the new model.

This latter approach is not an easy option. But as with all major regulatory change, firms that see MiFID as a strategic opportunity are most likely to succeed in the long run.