ESMA & Trading Venue Market Structure

ESMA: Final report: MiFID II review report on the functioning of Organised Trading Facilities

ESMA has released its final report on the functioning of OTFs. There are a number of interesting granular points for those interested in market structure - in particular, trading venues, brokers and technology providers.

There are two macro points that emerge clearly from the report. Firstly, judging by the diversity of responses there is still no consensus on what the trading venue perimeter is - from RFQs, to interactive bulletin boards, to buy side OMS/EMS - the perimeter still appears to be uncertain. ESMA's response to this, is in part, the promise of future guidelines... So more to come. Secondly, a market point is that the quantitative information presented by ESMA, in its view, confirms the continued significant presence of "human" lead/intermediated protocols and workflows in particular in relation to illiquid instruments.

The key points from the report are below.

Trading venue trigger provision moved from MiFID to MiFIR.

The provision triggering a trading venue authorisation will be moved from MiFID to MiFIR. The consequence of this is to make the prohibition on carrying out multilateral activity without a trading venue licence more explicit. Specifically, it will be confirmed that any entity that operates in a multilateral manner will be the trading venue, and "required to seek authorisation as a regulated market, MTF or OTF and, where necessary, modifying their operating arrangements to comply with the applicable trading venue definition."

This is to move away from national transposition under MiFID to ESMA, allowing for a more harmonised approach...

Technology providers time to reassess

Much of the report and many of the responses has been focused on technology providers/middleware providers.

ESMA has not provided definitive guidance in this space and has noted a diversity of business models. Specifically, ESMA has noted that, in its view, many of these business models should be viewed as multilateral and has rejected a number of the arguments often relied upon in this context:

"In addition, regarding systems operating in a similar way to a trading venue but without proper authorisation, ESMA considers that any system that allows third party trading interests in financial instruments to interact, including information exchange between parties on essential terms of a transaction (being price, quantity) with a view to dealing in those financial instruments is sufficient to require authorisation as a trading venue. The information exchanged does not need to lead to a contractual agreement within the system between parties for the interaction to occur."

The key term here appears to be "interaction" with an example in relation to "exchange" of "essential terms". Interaction implies or requires some form of two-way activity (in contrast to the classic one-way display of the bulletin board) and "exchange" likewise implies two-way activity. This appears to be focusing on systems that allow for notification or alerts when trading interests (size/volume) are entered. There may still be edge cases in relation to systems that contain one passive party (such as those who have requested a basic alert rather than tailored the alert) or systems where there is no view to "dealing" (the phrase dealing also appears to imply a pre-trade focus rather than a post-trade/nonprice forming "compression like" services that should in any event, in our view, be outside of scope).

Distributed trading systems

Related to the technology provider point above is the set of issues concerned with distributed ledger systems. As a starting point, MiFID is technology neutral so it has always appeared odd to consider distributed ledger systems as always being multilateral, or as always been bilateral. The point is that distributed ledger systems or trading systems in general can either be bilateral or multilateral regardless of the underlying technology. In the case of distributed ledger systems, there's the possibility to created purely bilateral system based on "nodes", rather than a multilateral system. However, ESMA notes that simply because it is the case that bilateral system can be constructed out of distributed ledger technology, this does not mean that such systems are not capable of being multilateral - where they are, this will require trading venue authorisation. And there are a number of trading venues emerging in the market that use such technology.

Bulletin boards

ESMA is intending to issue guidelines on the perimeter of bulletin boards. The guidelines will emphasise that bulletin boards are systems that do not allow for communication/negotiation between parties or any notification of any potential match between buying and selling interests in the system. This will have implications for technology providers but also crowdfunding platforms / providers in the secondary market; in some cases these entities could be considered multilateral and requiring trading venue authorisation.

Off book on venue trading (i.e. pre-arranged trades or process trades)

Pre-arranged trades are considered a separate form of activity by ESMA. For example, a broker does not become a trading venue simply by pre-arranging a trade between two clients that is then executed on a trading venue. This should never have been in doubt and existed as a protocol under MiFID I.

What is more puzzling is ESMA's suggestion that the broker who carries out the prearranging might be carrying out an outsourced "service" of the trading venue!

The outsourced service being presumably the "crossing activity"…This has a lot of implications, including triggering an EBA compliant outsourcing agreement between the trading venue and its members who cross prearranged trades.

ESMA notes "where the system where transactions are negotiated is multilateral, ESMA considers this system could be regarded as an outsourced service from the trading venue where the transaction are executed. The trading venue should therefore ensure, through contractual arrangements, that all relevant MiFID II provisions are complied with including rules relating to non-discriminatory access and fees."

Presumably, ESMA means "an outsourced service to the trading venue" rather than "from the trading venue". If so, the members of the trading venue become service providers to the trading venue? And the trading venue has to have an outsourcing agreement which covers the regulatory guidelines on outsourcing, including audit rights, termination rights, exit provisions, service level standards etc? And, given that a service provider, under an outsourcing, generally requires authorisation, where it carries out regulated activities as a service provider is ESMA suggesting that members require trading venue authorisation to carry out the pre-arranged trades?
Simply put, this can't be right.

A reasonable suggestion might be that an outsourcing is a service that is otherwise undertaken by the firm who is outsourcing it. The trading venue does not outsource pre-arranged trades, because it does not represent or agree that it is the one carrying out the arrangement of these pre-arranged trades. The pre-arranged trades are permitted, in part, because they are carried out under the trading venue rules (but, crucially, not carried out or represented to be carried out by the trading venue itself).

The best that can be made of the ESMA's phrasing is to read "could be regarded as an outsourcing" as "could but isn't".

Asset managers and fund level crossing

The issue of asset managers who cross financial instruments between funds they manage or other funds managed by a group entity is an old issue and ESMA has kicked it down the road and potentially into the long grass:

"In order to decide on the best way forward, further analysis should be conducted to understand how fund managers prevent conflicts of interest when operating internal crossing systems and how end-investors’ interests are safeguarded in particular when comparing to execution of relevant transactions via brokers or trading venues. Therefore, ESMA does not recommend any changes to the legislative text at this stage but may come back to this issue in due course."

There is one relatively straightforward point in relation to this area that could be made: where a fund manager crosses instruments between funds it manages there is no "substantive" third party, due to the funds being under the common control of the fund manager. This, therefore, avoids the accusation of multilateral activity. ESMA acknowledges this point in passing but stops short of viewing it as the end of the matter (and, admittedly, it is not a full response to crossing orders of funds that are not managed under the common control of a single manager - such as within groups).

Matched principal trading

There are no material changes proposed for OTFs but a welcome, if straightforward confirmation, that an investment firm that operates an MTF's can execute in a matched principal capacity when trading outside of the MTF.