mifid ii – otf and venue categorisation · even called the prodi amendment, named after the...

Memorandum

MiFID II – OTF and venue categorisation

Memorandum

6 June 2012, Brussels

Huw Jones�Regulation Correspondent, Thomson Reuters

Mr Jones started by looking back a decade. It was a different era. The euro had just been launched as the currency for trading shares across continental Europe. Stock exchanges like London, Frankfurt and Paris had entered a game of speed dating but marriage proved much harder. At the same time came the Financial Services Action plan and its revision of the Investment Services Directive. I remember covering pre-proposal meetings where people wondered what ISD II would look like. Suddenly ISD II became MiFID. The name of the game back then was to encourage competition and to end the concentration rule whereby stock exchanges have a

monopoly of retail trades. MiFID certainly did spawn a whole generation of new trading venues - BATS, Chi-X, Turquoise, Equiduct, etc. Nearly all failed to make any money but the mould was broken. Chi-X became one of the biggest trading venues in Europe and the percentage of UK trades on the London Stock Exchange fell to around 50 percent at one point. The proposal for a new category of trading venue, the organised trading facility or OTF takes us back to the huge battle during M i F I D I o v e r s y s t e m i c internalisation. At one time, it was even called the Prodi amendment, named af ter the European Commission president who intervened after exchanges worried that banks would be getting off too lightly and needed curbing. The SI system was duly passed and it was also duly ignored. Compet i t i on s t i l l came i n bucketsful with only countries like Spain, who simply ignored MiFID for years.

Memorandum MiFID II – OTF and venue categorisation

Will the OTF category be the new SI, to be ignored and worked around by clever bankers? Or will trading simply move elsewhere? W h a t s o r t o f u n i n t e n d e d consequences will we eventually see from MiFID II? Competition brought fragmentation under MiFID I. What will MiFID II bring that the regulators have not spotted? Mr Jones remembers when the O T F c a t e g o r y w a s fi r s t mentioned. The banks were worried because they saw it as the result of early, well-organised lobbying by Europe's exchanges taking a direct hit at their lucrative $ 6 4 0 t r i l l i o n O T C s e c t o r dominated by just 14 trading houses. After a closer look, the OTF looks a better bet than having to channel many of their b i la te ra l t ransact ions onto exchanges or other platforms. It is all relative these days as far as regulation is concerned. Our panel of experts today will help answer some of these q u e s t i o n s , c o r r e c t a n y misperceptions and shed light on what's to come. _____________________________

Anne E. Jensen Member of the European Parliament The amendments in the ECON committee go in quite diverse directions. Even in Ms Jensen’s own group she finds a wide variation in the responses. There are some members who like the idea of an OTF category but think it has to be clarified, while some other members think the ideas should be abandoned completely. Consequently, it is rather unclear what the outcome will be. Ms Jensen believes that at this stage, not even the rapporteur, Mr Ferber, has a clear idea of where we are heading. Therefore, this meeting is very timely. Argument still matters and it is still possible to influence the final outcome.


Some people think that the OTF category should not be there or that it is not needed. They are often of the opinion that derivative trading should be forced into regulated markets and MTFs. They basically want to go back to what was achieved with MiFID I, i.e. the free competition which most people think is beneficial. Those who would like to have an OTF do so because they want to keep what was good in breaking up the monopolies, but also because they want to see a level p l a y i n g fi e l d a n d g re a t e r transparency. In Ms Jensen’s view, transparency is key to what we want to achieve. There is a fear that too much trading is taking place within closed circles over the counter. Ms Jensen has put in some amendments herself and those reflect a concern that we find among many members. That is that they do not think the Commission’s proposal is clear enough on the difference between different markets, specifically the equity marker on the one hand and the bond and derivatives markets on the other hand. The issue is that equity markets are o r d e r d r i v e n w i t h b o t h

professional and retail market players and with rather small trading sizes, whereas the bond and derivatives markets are wholesale markets which are price driven and with very large trading sizes where you need market makers. What Ms Jensen would like to work in favour of is to have a modification of the OTF proposal so that we clarify how we treat equity on the one hand and bonds and derivatives on the other hand. For equities it is i m p o r t a n t t o h a v e n o n -


between the co-legislators. On this file we are still rather far away from the trialogue. The European Parliament will vote in committee in Ju l y and in p lenary i n September. As for the Council, the Danish presidency will not be able to achieve an agreement but hopefully the Cypriots will manage to do so in early autumn, so that perhaps we will achieve the goal that was set by the European heads of states and government in the beginning of March, i.e. to have a political agreement by the end of the year. Here you can count on the Commission to play i ts role in order to find a consensus. Ms Fábregas Fernandez focused on explaining why from the Commission’s standpoint, the new OTF category is needed. One of MiFID I’s key innovations was to eliminate the concentration rule. This was done by the introduction of the MTFs. I t st imulated competition and innovation in securities markets. But this innovation also encouraged organised trading in venues outside MIFID, for example on broker crossing networks. This was not against any rules; MiFID I just did not cover this. While

discriminatory access for all investment firms. This, along with the transparency, is also important in order to have a level playing field with the regulated markets. Ms Jensen does not believe that we should have proprietary trading for equities. Concerning the bonds and derivatives, Ms Jensen thinks that since these are professional, price driven markets where you need market makers, proprietary trading should be allowed on an OTF in order to assure that you have sufficient liquidity. _____________________________

María Teresa Fábregas Fernandez Acting Head of Unit G3 – securities markets, DG MARKT, European Commission The role of the Commission is to be a facilitator in the negotiations


scope of the instruments it regulates; in l ine with G20 commitments, al l trading in standardised derivative contracts will take place on regulated venues and transparency will be extended from equity to non-equity markets. A wide definition is required to appropriately regulate the venues where the t r ad i ng i n t hese d i f f e ren t instruments takes place. However, wherever the same business is conducted the same rules should apply to ensure a level playing field as well as e l i m i n a t i n g i n c e n t i v e s f o r regulatory arbitrage. Therefore transparency requirements will apply by reference to financial instrument – whether securities or derivatives – not by reference to the venue where the trade take place e.g. MTFs. Organisational


internal order matching has long been undertaken by brokers on a small ad hoc basis, technology has made it larger and systematic, and has broken the playing field against the regulated market. A lot of trading moved to the dark side of the market. Further, in light of the crisis, it is no longer a c c e p t a b l e , s o c i a l l y a n d economically, to leave significant areas of markets unregulated and opaque. The OTF is a key element of the proposal to address these concerns. It is broadly defined to capture all organised trading venues outside the current MIFID categories. Any system that brings together buying and selling interests on an organised basis will be classified as an OTF unless they are a regulated market or an MTF. The definition's flexibility firstly ensures a dynamic regime that can adapt to future innovations, i.e. it should be “future proof”. One of the reasons why OTF has been introduced is because in the MiFID II proposal the Commission is broadening the scope of transparency in the non-equity area. Secondly MiFID widens the

preliminary discussions that have taken place up till now with the European Parliament and the Council there is a will to already reinforce this calibration at level one conce r n i ng p re - t r ade transparency requirements for non-equit ies and not leave everything to level two and the Commission. The debate on OTFs is closely linked to that on pre-trade transparency and this debate will continue at the next QED event on pre- and post trade transparency. _____________________________

and market surveillance rules will be aligned and non-discretionary access rules will apply to OTFs. Nevertheless we have to take into account that OTFs are run by brokers, which have their licences as investment firms. Therefore, they have their compliance but they will have to set specific objectives for the requirements for accessing their venue. Those requirements should be the same for everyone. However, an OTF wil l have d i s c r e t i o n a b o u t h o w a transaction will be executed and so they will be subject to conduct o f b u s i n e s s a n d i n v e s t o r protection rules. OTFs will also be prohibited from executing orders against their own proprietary capital, thereby removing any conflict of interests - and also ensuring a level playing field with the MTFs. However this is not a ban on proprietary execution, rather it simply concentrates the activity in one category – the systematic internaliser. As for pre-trade transparency, further calibration and waivers will have to take into account liquidity and the specifics of different financial instruments. In the

Claudio Salini Secretary General, CONSOB Before, the world was easier to manage , t he ob j ec t i v e o f regulation being the orderly markets, efficiency and investor protection in a situation where there was a monopolistic pool of


liquidity. Regulators could focus on the information made available by stock exchanges and trades taking place off- exchange could be considered as ancillary. In some countries off-exchange trading was even prohibited, in others it was just not subject to regulation. In such a situation, regulation was basically focused on finding the proper balance between t ransparency and liquidity. Today, after MiFID and a financial crisis, the world and the mood have changed radically. How does this environment work and what are the lessons learned? Markets are more fragmented, both in terms of information and liquidity, and characterised by an increased level of competition between trading venues. Stock exchanges are no longer the only source of information. In the past, exchanges were seen as an “authority”; today exchanges are more and more focused on competition. Therefore, today the level playing field between trading venues becomes a new and important regulatory objective. The market crisis made evident the lack of information available/

transparency, especially in the b o n d m a r k e t . C o m p e t e n t authorities’ reaction to the crisis proved to be slow, also because of lack of information and lack of tools available to cope with the i ssues . Fu r the rmore , se l f -regulation proved to be ineffective and regulated markets showed that they may not have the proper incentives to reach the “optimal” outcome. Finally, for the first time, taxpayers (and not only investors) were involved and gained in importance as stakeholders. There is a need for additional tools and information to promptly react, espec ia l l y t he bonds and derivatives markets. In addition, regulation is expected to prevent market failures and not to react to them. Safety and efficiency are now on an equal footing and stability come first. Transparency


is no longer only a tool to reach the efficiency and improve the price discovery process : it represents also a tool to ensure the stability of the financial system. The question is: will MiFID II be able to reach all the objectives? There is an increasing request for regulatory intervention, both in terms of degree and areas to be covered. The introduction of a new trading venue category (the OTF) represents an attempt to reduce the number of “grey areas” and ensure that all the multilateral trading venues are subject to transparency obligations. O T F s n e e d t o b e c l e a r l y differentiated from other trading and execution venues. Current draft proposals do have some elements in this respect: OTFs will

be multilateral whilst systematic internalisers are bilateral systems; OTFs cannot trade on their own account, which is something only systemic internalisers will be allowed to do; OTFs will be differentiated from MTFs and regulated markets in that there will be a certain level of discretion in the execution of orders. Under a theoretical point of view, the new approach will work perfectly; in fact it should be taken into account the market impact and the difference between var ious asset c lasses. The equit ies world is easier to approach in that the trading on stock exchanges already provide a clear reference point. MiFID I could be considered a track record so that we now know more on how markets work. If broker crossing networks are added to the scenario, something changes, but not the price formation. There are investment firms and operators on which there is an impact. For a broker crossing networks who trades on their own account there may be an impact, but Mr Salini sees this as more of a micro impact rather than a macro impact.


It is more difficult to draw any conclusion for bonds. This is the first time that we try to regulate this market. When MiFID I was debated there was a strong negat ive react ion f rom the industry on the attempt to make bond markets more transparent. the reasons being the absence of any specific market failure and the well-functioning of the self-regulation. This is also the first time that we try to regulate pre-trade transparency (together with post-trade transparency) for which the trade-off between liquidity and transparency is much more difficult to assess and manage. We do not have any track record here, like we do for the equity markets. Prices are mainly set outside regulated markets, with the exception of Italy where bonds are traded on mult i lateral t rading venues. Cross ing ne tworks and in particular voice brokerage play a role in the bond market, which is different if compared to the one played in the equities market: they play an active role in the price formation process. Everything is st i l l open for discussion and Mr Salini asked the industry to be cooperative in

the shaping the new MiFID II directive. There is a strong demand for more regulation. What happened in 2008 showed that there was a lack of information available to the regulators in order to act promptly. We need more information both for the regulators and for the market itself but we need to avoid the risk of an overreaction. _____________________________

Ryan Chidley Senior Equity Trader, APG Assessment Mr Chidley gave an overview of how the automation of the trading has increased since the 1990s. More and more roles in the industry are being replaced by software, starting at the bottom of the food chain, i.e. the market maker and the floor traders, and slowly working its way up.


A buy-side trader defines a trade according to the level of urgency and according to size. The easiest trades are of course those that are not urgent and small relative to the liquidity of the market. Those are increasing automated orders. For a pension investor like APG, most orders are however categorised as not urgent but large vis-à-vis the liquidity. Buy-side traders view venues as “safe”, “careful” or “dodgy”. On the safe side you have a low probability of getting your order done but there is a high potential for liquidity and there is minimum risk of someone figuring out what it is you are trying to do. Venues in this category are MTFs such as Liquidnet and certain broker crossing networks. Here you find large pension funds trying to buy or sell large blocks of a stock. Then you have the “careful” venue, where you find large asset managers but who may have internal hedge fund strategies or quantitative strategies. Here you have “indicating to sales traders”, “indicating to cantors and broker IOI”. Finally you have “dodgy” venues where you have higher probability of a fill but there is a greater risk that someone will

figure out what it is you are doing and liquidity is limited. In this category you have other dark pools and exchanges. The reason why regulated markets are among the least preferred places to trade is because of the presence of high frequency trading and the small order sizes. The sales traders on the other hand, have the same image in mind when receiving an order. When they receive an order for a block of stocks they are faced with the task of finding a counterpart for that trade. If the trade is urgent they will go quickly from safe to careful and finally to dodgy. If the trade is less urgent, the sales trader will stay in the safe category for a day or two and not do anything else. Discretion is defined as customisation of counterparties per order, per


client, per order-client and, per market environment.

Looking at the MiFID II proposal from a broker crossing network’s perspective, what is crucial is d i s c r e t i o n a n d p r e - t r a d e transparency waiver based on reference price. Moreover a opt-in for broker capital is desired. From t he buy -s ide pe r spec t i ve , discretion is the most important. The buy side also wants a pre-trade transparency waiver but not based on reference price. It would be good with an opt-in for broker capital but it is not a game changer. What is more important is disclosure to the client of the BCN logic. From the regulator’s perspective, one of the most important things

is the curtailment of pre-trade t r a n s p a r e n c y w a i v e r s . Furthermore, greater transparency of BCN activates and curtailment of proprietary capital is desired.

The compromise for an OTF could be that first of all it would be defined by its discretion. It would be different from an MTF or a

systemic internaliser in that it can customise the counterparties based on client’s guidance. This could be particular to a specific trade or to a specific client. The compromise should also include a pre-trade transparency waiver based on scale. Mr Chidley also would like to see disclosure of OTF logic to the client. Negotiable points would be proprietary capital and the size of the large-in-scale waiver.


mifid ii – otf and venue categorisation · even called the prodi amendment, named after the...

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