Following on from the MAR report in my last blog comes one on a consultation from ESMA concerning the Organised Trading Facility (OTF) Regime. The accompanying paper provides an overview of the functioning of the OTF regime. It discusses the definition of OTF’s, the use of discretion in the execution of orders and the practice concerning the use of matched principal trading. In dealing with the definition of an OTF, the paper focusses on the definition of a multilateral system. This also includes some analysis concerning the boundaries of trading venue authorisation and OTF’s use of “discretion”. After the consultation closes on the 25th November, the European Commission is then required to present a final report to the European Parliament and Council of the EU on the functioning of OTF’s after consulting with ESMA. The final report is expected by March 2021.
One of the key parts of the consultation stems from ESMA receiving concerns about firm’s operating systems that function in a similar way as multilateral systems, but without being authorised as a trading venue. In MiFID II, a multilateral system is defined as “any system or facility in which multiple third-party buying and selling trading interests in financial instruments are able to interact in the system”. ESMA interprets this as systems where trading interests can interact but where the execution of transactions is formally undertaken outside the system. However, these systems would still qualify as multilateral systems and be required to seek authorisation as trading venues.
They further note that it is forbidden to operate any type of multilateral system that does not also fit the definition of a Regulated Market (RM), MTF (Multilateral Trading Facility) or OTF. Thus, all multilateral systems should seek authorisation as an RM, MTF or OTF and where necessary modify their operating arrangements to comply with the applicable trading venue definition. On top of this, ESMA is of the opinion that systems that provide quote streaming and order execution for multiple Systemic Internalisers (SI) should be considered a multilateral system. This all leads to the “devil in the detail” when the analysis is extended to software providers.
Many have held the view that the regulatory treatment of software and middleware providers has been somewhat unequal; especially so when these technology firms work as aggregators. ESMA singles out aggregators as providing enhanced access to various sources of trading interests including MTF’s, dealers, single bank platforms and the like. Given the different types of providers and business models involved it makes their regulatory analysis very challenging. Concerns have been raised that these firms are de facto operating multilateral systems without being regulated. Many voices that are focal contend this leads to regulatory arbitrage and an uneven playing field. ESMA themselves notes –
“Stakeholders also stress that those firms, on their website, use a terminology that is very close to the business of a trading venue and which is deemed to give an indication about their real business. They indeed advertise themselves as providing “electronic trading solutions”, “execution management systems”, “e-trading solutions” or even “trading systems”. Another aspect of relevance commonly mentioned is the type of fee charged by those software providers. While some are based on a software license pricing model, other are charging clients based on brokerage fees (i.e. fee per trade or based on volume traded).”
This leads ESMA to conclude that the concept of multilateral systems should also apply to software providers. Prior to the consultation, software providers had argued that because the ultimate execution of transactions was concluded outside of their system, this demonstrated that the system was not multilateral and that they did not need to seek authorisation as a trading venue. ESMA take the view that this should not be the case and notes “the fact that finalisation of transactions negotiated through the software does not formally take place in the system but on an authorised trading venue or Over the Counter (OTC) should not exempt the software provider to seek authorisation as a multilateral system under MiFID II.”
As the nights began to draw in with the onset of Autumn, I read an interesting paper by the Dutch Authority for the Financial Markets (AFM) entitled “A review of MiFID II and MiFIR Impact on the fixed income and derivative markets.” The AMF addressed the Level Playing Field theme and noted that MiFID II introduced the OTF as a new type of trading venue. They further noted –
“At this stage, it is becoming clear that the boundary between a regulated multilateral venue and a technology/communication platform is thin. Since MiFID II has significantly raised regulatory burdens for operating a trading venue, this has incentivised firms to avoid these costs and operate close to or beyond regulatory delineations. Sometimes even unintentionally.”
They went on to state that trading venue-like operations by commercial banks, as well as bank-operated SI’s face similar degrees of supervision and regulatory scrutiny. A third level playing field issue concerns the requirements of Article 17 for algorithmic trading and high-frequency trading. With the introduction of MiFID II and the growth of electronic trading, SI platforms are becoming increasingly crucial for price formation and face similar risks of causing unorderly trading. To ensure orderly markets and protect the level playing field with multilateral trading venues, SIs should be included in the algo trading requirements.
This Halloween there will be many technology firms and banks studying the Devil in the detail and uncovering many ghouls to haunt their thinking as they hide in the dark away from the gaze of the regulator. Equally, many banks operating as SI’s will be spooked by the thought that they may need to assess the business models of their Internalisers and use of algorithmic trading. Looking at the way these functionalities are often presented may see them having to jump into the cauldron of trading venue regulations.