MiFID II/MiFIR: share trading obligation

Introduction

The Share Trading Obligation has been a known problem to the industry since it was negotiated as part of the MiFID II package. However, it is only in the last year that firms have focused on how to incorporate the obligation into their business models; creating significant problems. In particular, international booking arrangements and the practice of transmitting orders to non-EEA venues/counterparties, where there are deeper pools of liquidity, could be substantially curtailed, if not (in some cases) prohibited. For example, where a firm formerly sent an order for execution in a foreign jurisdiction (such as the US), seeking the deepest pool of liquidity, this may no longer be possible (see example below in relation to Apple), unless a solution/compromise is settled upon. In this briefing we address issues arising out of the Share Trading obligation in relation to:

1. arranger/transmitter models;
2. matched principal models;
3. booking models; and
4. non-EEA Branch models.

We draw attention to possible solutions suggested by industry, in order to highlight the options and scope for flexibility that public authorities have.

Article 23 of MiFIR requires an investment firm to ensure the trades it undertakes in shares admitted to trading on a regulated market or traded on a trading venue take place on:

(i) regulated market, multilateral trading facility ("MTF");

(ii) systematic internaliser ("SI"); or

(iii) a third country trading venue assessed as equivalent in accordance with Article 25(4)(a) of MiFID II (the "Share Trading Obligation").

There are two exemptions to this significant obligation, which are discussed below. However, to put the problem in its starkest terms EU investment firms will not be able to carry out transactions, in dual listed securities, on foreign markets. Instead, they could be forced to undertake this transaction on the EU trading venue, with best execution suffering.

As with many regulatory issues these days, there is a Brexit point to be made here. Specifically, whether UK trading venues will be considered third country equivalent venues and therefore be eligible to have shares (and derivatives in due course) traded on them by EEA-based investment firms. This is an important point for UK trading venues that have already started considering their business models and whether they need to get some of the wheels turning on establishing an MTF in another European country.

The Share Trading Obligation: The Framework

The obligation is, as noted above, that an investment firm has to ensure that the trades it undertakes in shares which are admitted to/traded on a trading venue shall take place on a trading venue, SI or a third country trading venue assessed as equivalent (there are a number of narrow carve-outs which we discuss below). Unfortunately, the provision is not limited in scope by the terms of Article 23(1) of MiFIR to any significant degree. Instead, the scope is limited seemingly only by the nature of the instrument, which mirrors in some ways the approach taken under Market Abuse Regime ("MAR"). The extraterritorial reach of MAR has long been justified by the specific policy concerns regarding market abuse and the need for orderly markets. However, these policy concerns do not exist in the same degree or nature in relation to the Share Trading Obligation and should not be automatically reasoned across.

The Consequences

If the Share Trading Obligation (and its exemptions) are not interpreted with some flexibility the following counterproductive consequences will arise:

(a) execution will often not be carried out in the jurisdiction with the deepest liquidity, i.e. shares which are thinly traded in the EEA may be required to be traded away from deeper pools of liquidity in, for example, Asia or the US. It is clear that this will damage best execution and investor protection. To take a well-known example, Apple Inc has its primary listing on the Nasdaq and naturally the majority of liquidity in relation to that stock is traded on US venues. Apple is also traded on Deutsche Börse's Xetra Stars as an EU trading venue. The average number of trades each day on Xetra Stars is approximately 164 vs 60,745 in the US; the average daily traded value is €2.8m in the EU vs €4.2bn in the US (these figures are indicative rather than static). In order to access this liquidity, EU investment firms that are not members of Nasdaq or other US venues will generally route client orders to US brokers who are members in order to achieve best execution.

However, this arrangement could be about to end under MiFID II. Under the trading obligation an EU investment firm may not be able to access foreign markets in the same way as previously. Of course, if Nasdaq received status as an equivalent third country venue this would permit EU "investment firms" to execute transactions on it. However, this does not deal with the issue that significant amounts of volume are traded away from the lit order book - this kind of liquidity would not be available to EU investment firms. Instead, the EU investment firm would have to execute (for example) on Xetra or an SI (i.e. EU investment firm dealing on own account);

(b) firms that are not MiFID investment firms but are otherwise regulated under AIFMD or UCITS are not subject to the Share Trading Obligation. This creates a curious imbalance in the regulatory framework allowing those firms to reach deeper pools of liquidity, which may soon be beyond the reach of MiFID firms. In other words, clients of AIFMs and UCITs will get better execution than clients of MiFID firms; and

(c) most importantly perhaps, financial centres such as London, Paris and Frankfurt will have to undergo significant behind-the-scenes restructuring in relation to booking models. These jurisdictions have historically acted as booking centres for group affiliates located in Asia/US. However, the Share Trading Obligation casts doubt on whether these types of arrangements will continue to be possible in relation to shares.

Taking the above consequences into account, commentators and academics such as Moloney have cautioned that:

"if equity market liquidity is not to move offshore to more accommodating venues, great care will be needed in amplifying the conditions under which equity trading can take place on a regulated market, MTFs and SIs, and exemplifying the exemptions from Article 23 MiFIR (Moloney, 2014, 468)".

There is a risk that if caution is not taken, unnecessary damage might be done to both the investor protection and the plumbing of the financial architecture.

Solutions

A number of solutions have been suggested and it is important to highlight these, in order to understand the possibilities for a different outcome:

(a) Interpretation of the meaning "undertake": This is the phrase used in Article 23 MiFIR in relation to the Share Trading Obligation. However, its precise meaning is left undefined. It is important to treat the phrase with care as it is capable of both being narrowly or widely constructed with significant implications in either case;

(b) Equivalence: Where a third country venue is deemed equivalent by the Commission, then EU investment firms are permitted to trade on this venue. Currently the market has no timetable for such assessment and are somewhat in the dark as to which venues will be equivalent (will US ATS systems be equivalent, for example?). Additionally, there is no such mechanism for third country SI equivalence (i.e. own account trading) and therefore cross-border risk trading may decrease; and

(c) Short selling regulation analogy: a number of trade associations have highlighted how the Share Trading Obligation may be interpreted against the background of the EU Short Selling Regulation (the "SSR"). Article 16 of the SRR states that the net short position notification requirement (the public disclosure requirement) and the restrictions on short selling (buy-in requirements) are disapplied for shares admitted to trading on a trading venue in the Union where the principal trading venue for the trading of the shares is located in a third country. The SRR exemption should be imported into the Share Trading Obligation. For example, the transactions set out at RTS 1 that do not contribute to price discovery should refer to transactions in shares of a company admitted to trading on a trading venue in the Union where the principal venue for the trading of the shares is located in a third country in accordance with Article 16 of the SSR.

(d) Best Execution: an acceptance that best execution obligations cannot be overridden by the trading obligation and that enforcing a strict interpretation of the trading obligation is not "proportionate" to its intended objectives or the wider MiFID II objectives of "investor protection". Although the legal theory behind this appears difficult, it may be a possible and reasonable solution, as two public authorities have declared, in public, that they would not expect the trading obligation to overall best execution.

The Meaning of "Undertake": Arranger/Non-Execution Models

Although the scope of the Share Trading Obligation does not appear to be limited significantly by the terms of Article 23 of MiFIR, there is a point in relation to the interpretation of the word "undertake". How this is interpreted is crucial in relation to applying the obligation to particular business models. Specifically, is there intended to be any difference between the meaning of "undertaken" and "execute"; is the former wider than the latter? Does, for example, the meaning of "undertake" include what is in European [speak] reception and transmission of orders (and in UK [speak] Article 25 arranging of orders)? Or should a more narrow interpretation of the obligation be taken as relating solely to "execution" of an order itself? The consequences of this are important, because if a narrow interpretation is taken an EU firm could continue to act as arranger for an EU client and a US broker/execution venue (as in the diagram below).

Arranger Model

The above diagram shows a typical arranger model involving third-country execution. In this scenario the EEA firm is either "arranging" or "transmitting" the order where it passes this to the non-EEA broker (often an affiliate) for execution (the execution itself being outside of the EEA). This model is more UK-centric than European given the UK's more flexible overseas person regime.

If a wide interpretation of the Share Trading Obligation is adopted, the EEA firm would not be able to arrange for its non-EEA affiliate to execute the order; it would need to carry out the order on an EEA or equivalent overseas venue (it is also common for business models to operate according to a matched principal structure on a back-to-back basis. We more fully discuss this separate structure below as it should be considered separately from the "arranging/transmitting" issue).

Currently there is a risk that public authorities appear to take a wider view of the interpretation of Article 23 of MiFID II. The public policy concern is that a narrow interpretation would give rise to anti-avoidance strategies. In this regard it is argued that it would appear possible to circumvent the Share Trading Obligation if it did not apply to "arranging". However, this is open to challenge. The first point is that firms would only be permitted to send an order to a non-EEA jurisdiction in compliance with best execution; therefore this places immediate limits on where order flow can be directed.

The second more substantive point is that there is an argument that this structure (the Arranger Model, as shown in the diagram above) is not an avoidance mechanism but is intended or envisaged by the draftsperson. This is the case as the Share Trading Obligation appears to have been drafted specifically with "execution" in mind. In this respect, the distinction between an order and a transaction is relevant and is one which has been developed in other areas of MiFID and also under MAR. In this view, a transaction relates to the actual execution of the order and would fall under the perimeter of the Share Trading Obligation. Here it is that the executing firm that is required to ensure that the trade is placed on a trading venue, third country equivalent or an SI. Conversely, an order or transmission of an order is not an "execution" and would, accordingly, fall outside of the Share Trading Obligation. The underlying logic is that the Share Trading Obligation is intended to control execution decisions that are taken in the EU by MiFID firms – in other words, where the MiFID firm has execution discretion, MiFID should apply, but where the execution decision is taken outside the EU, local rules should apply instead. Some further support for this can be found in other areas of MiFID II. For example, under the transaction reporting regime, transmission of an order is explicitly deemed an "execution", i.e. the draftsperson has explicitly widened the definition of "execution" in a way that contrasts with that of the Share Trading Obligation.

Finally, legislative support for the above view can be derived from recital 12 of MiFIR, where it is stated that the "trading obligation requires investment firms to undertake all trades including trades dealt on own account and trades dealt when executing client orders on a regulated market, an MTF, a systematic internaliser or an equivalent third country trading venue". This recital appears to be referring to transactions that are executed rather than orders which are transmitted/arranged. In one view, therefore, the recital wording is clear on the point: trades including those dealt on own account (i.e. those transacted/undertaken on own account) and trades dealt with when executing client orders (i.e. not the transmission or the arrangement of an order but the actual execution of a client order) are the type of transactions caught by the Share Trading Obligation. If this principle is accepted then some of the negative consequences of the Share Trading Obligation fall away (although not all). In particular, it would allow firms to continue to arrange/introduce EU clients to third party brokers/execution venues.

Matched Principal Trading

The above only deals with one part of the Share Trading Obligation. In particular, it does not address issues regarding matched principal trading (under the MiFID II definition) or back-to-back trading (here taken to mean a similar trade pattern to matched principal trading but without the requirement to be simultaneous). In relation to matched principal trading, MiFID II provides a seemingly inflexible definition which, in short, requires a firm to execute two legs of a trade simultaneously (for no profit/loss other than previously disclosed charges, commission, etc.). The Share Trading Obligation, currently construed, would prevent an EU investment firm receiving a client order and executing a market leg to satisfy this order outside of the EU (such as in the Apple example set out above).

There are a number of possible suggestions in relation to the above problem:

(a) the EU investment firm becomes or is an SI and therefore is a permissible execution venue under the Share Trading Obligation as such. This, however, requires a degree of flexibility in the interpretation regarding the market side of the SI trade, i.e. currently the SI would not be able to undertake its market side trade outside of the EU/Equivalent Third Country venues (save for the exceptions). It is not clear that this kind of flexibility will be forthcoming. One possibility here is to interpret the obligation in line with the post-trade analysis. For example, a MTCH transaction has a single post-trade reporting obligation. Would it be acceptable to argue that the same should be true of the Share Trading Obligation, i.e. it is a single transaction and where part of the transaction is executed on a trading venue or SI (here an SI for the client leg), and is this within the permitted perimeter of the obligation?; and/or

(b) adopt the SSR position (set out earlier) whereby trades are permitted to be undertaken outside of EU execution venues where the primary pool of liquidity is outside. of the EU

Booking Arrangements

Traditional booking arrangements are also under scrutiny, given the consequences of the Share Trading Obligation. For example, a typical booking arrangement involves a non-EEA affiliate carrying out a transaction and booking the risk of this back to an EEA investment firm.

Standard Booking Model

The structure set out above is a basic model and there is, of course, significant variation on the theme. In particular, booking models can have the following features:

(a) the EEA firm may act solely as a capital hub and therefore take the risk of the trade;

(b) the EEA firm may provide pricing in respect of its non-EEA affiliate, in order for the latter to execute the client leg; and

(c) the non-EEA affiliate may be trading as agent on behalf of the EEA firm (in addition to all the above).

In all of the above, however, it is the non-EEA firm that undertakes the execution rather than the EEA firm. Even where the non-EEA affiliate is trading as agent this is the case, despite the non-EEA firm trading on behalf of and for the EEA firm. A number of points follow from this conclusion:

(a) the non-EEA affiliate does not, where undertaking the trade as agent of the EEA investment firm, have MiFID obligations transferred to it. On this basis the non-EEA affiliate would be executing the orders subject to local law and regulation and this would include the fact that it would not be subject to the Share Trading Obligation and could execute such an order where it wished (subject to local law);

(b) the trades undertaken by the non-EEA affiliate may be for the EEA investment firm itself. In the above diagram the non-EEA firm is executing orders for its clients (1) and booking these back to the EEA firm (3). However, the non-EEA client does not have any visibility over this booking arrangement; from the client's perspective the trade is delivered to it or its account (the plumbing that sits behind execution is only disclosed where relevant);

(c) the client terms of business could be between the EEA firm or between the client and the non-EEA affiliate. However, where the terms are with the EEA firm these would typically state that the trade could happen between the client and a non-EEA affiliate and, in the latter case, this would be subject to local law, rather than MiFID regulation;

(d) the trades, when they are "booked" back, would appear on the EEA firm's balance sheet and be brought within the scope of the EU perimeter (not because of a client-facing trade but because of an intra-group risk transfer). In relation to this trade a number of MiFID obligations could potentially arise. For example, such a transaction could trigger a transaction report and a post-trade report obligation for the EEA firm. Importantly, from the perspective of this note, this transaction leg could be viewed as subject to the Share Trading Obligation primarily because of the absence of an intra-group exemption (such as in EMIR). If this was the case then the only way an EEA firm could continue to arrange itself in this manner and comply with the Share Trading Obligation would be the following:

(i) if it immediately carries out a MTCH/back-to-back transaction (on venue) in relation to the booked order (following the analysis given above in relation to such orders, if such an analysis is agreed by the public authorities and there is some doubt as to this);

(ii) if it was an SI (the consequences of which are that it would have to provide quotes to clients subject to a reasonable commercial policy); or

(iii) if it established a non-EEA booking centre for non-EEA trades (something which most firms do not have time to do before the MiFID II start date).

(e) However, these kinds of "intra-group" risk transfer trades can be compared to a type of "give up", i.e. the execution has occurred outside the EEA and following this there is an intra-group "give-up" of the transaction for risk-management purposes. Under RTS 1 "give-ups" are defined as "a transaction where an investment firm passes a client trade to, or receives a client trade from, another investment firm for the purpose of post-trade processing". There are therefore two questions that arise:

(i) Does it matter that one entity in this arrangement is not an "investment firm"? To answer this question, the logical position is that it should make no difference whether the transaction is carried out between an investment firm or a third country firm that would have been an investment firm had it been within the "Union" (Article 4(57) MiFID II) – put differently, the policy rationale for the exclusion still exists. On this basis, it would appear sensible for this to be generally interpreted as applying equally to investment firms and to third country firms under Article 4(57) of MiFID II. It would be useful (although perhaps unrealistic) if the EP could use its objection period to make this point so that the issue could be put beyond doubt.

(ii) Is the transaction for "post-trade processing"? Give-ups come in a number of varieties and it is important for the exclusion to the Share Trading Obligation (as well as the exclusions to transaction reporting and trade reporting) that the give-up in question is in relation to "post-trade processing". A clear example of this is a give-up in relation to clearing and settlement. There are different policy rationales for the exclusion in relation to give-ups for trade reporting and the Share Trading Obligation, compared with transaction reporting, which are important to keep in mind. In relation to transaction reporting "give-ups" are excluded when carried out in relation to clearing and settlement (given that market abuse concerns do not stretch to the need to identify a transfer of a transaction to a CCP), while in the trade reporting and Share Trading Obligation context the exclusions are primarily there as the transactions do not contribute to price formation/ discovery in any meaningful sense. Taking this and applying it to the intra-group transfer (in the booking scenario set out above) the transfer appears to be for post-trade processing, in the wider sense that the trade's risk is being transferred for risk management/capital purposes to another entity post the execution. In this respect, it is similar (in intention) to a give-up that is transferred to another entity for clearing and settlement (i.e. which in effect transfers some of the economic risk from the executing entity to the CCP). Therefore, given the give-up occurs post-trade it seems to appropriately fall within the exemption to the Share Trading Obligation for non-price forming trades.

The Problem of Branches

The starting legal principle in relation to branch-based questions is that a branch is not legally separate from the entity of which it is a branch (in contrast to an affiliate which is a legally distinct and separate entity). The legal indivisibility of a branch has given rise to a number of regulatory issues and features across the public policy spectrum (for example, the regulators are constantly shifting the perimeters in relation to the treatment of capital consolidation and prudential matters with regard to branches). In the context of MiFID, the European Commission has provided some well-known and difficult-to-square guidance on the matter of branches. On the one hand it states that, with regard to conduct/investor protection matters, non-EEA branches of EEA firms do not have to apply MiFID standards. This is all well and good, given that such branches would be under (potentially) conflicting local laws; the policy purpose behind the carve-out is clear and also follows the FCA transposition of MiFID in relation to its SYSC and COBS Handbooks (and to a lesser extent under its MAR Handbook). On the other hand, it states that where a non-EEA branch carries out a transaction, such a transaction will be seen on the EEA entity's balance sheet and therefore this transaction triggers a number of MiFID requirements, such as post-trade reporting. Nevertheless, The FCA has generally taken a pragmatic view of this principle.

However, under MiFID II and MiFIR the waters are more muddied in a number of respects, including with regard to pre- and post-trade transparency. Specifically, in relation to the Share Trading Obligation, it could be argued that because the branch is indivisible from the legal entity, it is subject to the Share Trading Obligation (in the same way the legal entity is, according the European Commission, subject to a post-trade disclosure requirement).

Branch Model

The above diagram illustrates the issue. The dotted line at (3) indicates that no transaction has taken place between the EEA investment firm and the non-EEA branch, but because the entity is indivisible from the EEA investment firm, the Share Trading Obligation could be argued to apply to the branch. However, for the reasons provided by the European Commission in relation to investor protection and conduct of business, the better to interpretation this is that such an obligation should not apply to the non-EEA branch.

There is no clear golden thread to be discerned in the European Commission's reasoning behind disapplying certain provisions of MiFID to non-EEA branches of EEA investment firms, and applying others. If, however, investor protection measures are not applied, but those that relate to a transaction appearing on a balance sheet are taken as a dividing line, the Share Trading Obligation arguably should fall outside of the non-EEA branch obligations, in the same way that best execution does (which is also concerned with the execution of an order).
 

The Exclusions 

There are two primary exclusions under Article 23 of MiFIR which merit brief discussion. These are:

(a) that the trade is non-systematic, ad hoc, irregular and infrequent (the "De Minimis Exclusion"); or

(b) is carried out between eligible and professional counterparties and does not contribute to the price discovery process (the "Price Discovery Exclusion").

Taking these in turn, in relation to (a) there is no ESMA mandate to specify what non-systematic, ad hoc, irregular and infrequent means. Nevertheless ESMA has offered an opinion, albeit somewhat in passing and in non-binding form. Specifically, at page 84 of the Final Report, ESMA states that the terms used to define the De Minimis Exclusion criteria are similar (although in opposite terms) to the criteria used in relation to Article 4(1)(20) of MiFID II to characterise systematic internalisation. In this context, ESMA believes that it would be useful for the European Commission to clarify the potential linkages that might exist between the two regimes (i.e. the trading obligation for shares and the systematic internaliser regime). Clearly, ESMA's suggestion that the Share Trading Obligation and the SI tests are interpreted on a similar footing, permits a degree of OTC trading that would reduce some of the negative consequences of the Share Trading Obligation discussed in this note (however for various reasons it is understood that such a view will not be generally adopted) .

In relation to the Price Discovery Exclusion, this is further specified by Article 2 of RTS 1 which lists a series of transactions that do not contribute to the price discovery process. These include, for example, transactions executed by reference to a price that is calculated over multiple times instances according to a given benchmark, or by reference to a volume-weighted average price, securities finance transactions and portfolio trades.

Conclusion

It is clear that if the trading obligation is widely interprete there is the potential to damage the current architecture of trading in the EU. In particular, an overly wide interpretation of the word "undertakes" and a lack of political flexibility regarding the interpretive options would give rise to a more fragmented less international trading system. It would also, in certain cases, give rise to best execution concerns for clients who wish to trade non-EU instruments. Some political and regulatory goodwill is needed on this issue sooner rather than later; and we expect ESMA to provide level 3 guidance on this topic very shortly.