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AFME’s Securities Trading Committee Chairman Stephen McGoldrick unlocks the latest MiFID proposals and looks at the rules for Organized Trading Facilities, algo trading and a consolidated tape.

Organized Trading Facilities (OTFs)
The OTF regime began life as a specific regulatory wrapper to put around broker crossing systems, (which are a new mechanism for delivering an existing service). Crossing, which is almost the definition of a broker, has become highly automated. Whilst most crossing activities have not changed, other aspects of the industry were seen to require regulation – namely increased automation and greater scope of crossing. The initial proposals outlined an umbrella category of systems called OTFs, with one category created to hold broker crossing systems and another to hold the systems for G20 commitments around derivatives trading.

Stephen McGoldrick, AFME Securities Trading CommitteeWhen the MiFID II proposals came out at the end of 2011, the ‘umbrella’ aspect had been simplified into a structure intended to be ‘all things to all people’, which is where it has come undone. MiFID II has created a regulatory receptacle for a practice and the two things differ in shape. The broker crossing system does not fit into the receptacle that has been created for it because much of the trading is against the books of the system’s operators, which is prohibited under the current proposals.

The regulators do not want speculative, proprietary trading within these systems, but unwinding risk created by clients is both useful and risk-reducing. An opt-in mechanism for compliance, allowing traders to decide if they want their orders traded this way may be a solution. Conflict management of this sort is common in the financial sector, as it ensures that any discretion is not exercised against the interests of the client. Certainly, when it comes to measuring the client’s interests against the operator of an OTF, it is absolutely unambiguous that their interests must come first. Therefore, any exercise of discretion that disadvantages the client relative to the operator is already prohibited. A formal, documented process to ensure that segregation stays in place is good, but to effectively prohibit the vast majority of trading on broker crossing systems seems to abandon the regulators’ objectives – to increase transparency and protect clients.

Furthermore, trades allowed into a broker crossing system would be instantly reported, creating post-trade transparency. The current proposals call for OTFs to be treated in the same way as Multilateral Trading Facilities (MTFs), which fosters uncertainty about the waivers for pre-trade transparency. Currently, there are clear criteria for granting a waiver to a platform: one is that orders are large in size, the other is taking reference prices from a third party platform. The Commission will not, however, be making the decisions about waivers; they have been handed to the European Securities Market Authority (ESMA) to determine. There is a danger in specifying too stringent limits for these waivers, which would create a very different landscape from that explicitly envisaged by MiFID I.

Systemic Internalisers (SIs)
Our understanding is that regulators did not want to split activity that was in an OTF into two, but rather to regulate the broker crossing systems and to remove the subjectivity of SIs. The current SI proposal is aimed at regulating automated market making by banks, so that institutions make markets by reference to market conditions, not by reference to their clients. In MiFID I, the SI regime was introduced to protect retail investors, but subsequently this seems to have changed. When the European Commission (EC) was asked by the Committee of European Securities Regulators (CESR) to clarify the rationale for an SI regime, they declined to do so. As a result there is a distinct lack of clarity regarding the intent of the SI rules. If we had a clearer vision of the direction the regulators wished to take the market, then it would be far easier to assess whether the regulations were moving us in the right direction – or not.

Will Psomadelis, Head of Trading, Schroders Australia and Stuart Baden Powell, RBC Capital Markets discuss the effects of artificial liquidity providers on the trading costs, speed of trading and market structure.

Stuart Baden Powell: We have all read and heard a range of industry opinion about HFT over the previous few quarters, be it from HFT themselves, from investment banks who provide services to HFT or execution venues who are part owned by HFT and happy to create pricing mechanisms such as the ‘maker taker’ or specific order types to attract HFT-type flow. Some banks view the HFT servicing part of their electronic trading desk as a tool for market share gains where commission charges are negligible, yet the payback is the benefit of increased control of liquidity and the boost to corporate business.

Execution venues are frequently judged on market share, but perhaps genuine value-added to the price formation process (not just the spread), reliability and overall liquidity quality should also be factored in. Bringing these points together, a question to pose is what the purchase price for Chi-X Europe would have been if it were itself publicly traded, exposed to full analyst transparency and recommendations, or even not principally owned by investment banks and HFT?

Dropping a level, practice-based publicly available knowledge on HFT is still limited. ESMA has noted the primary techniques being “usually either quasi market making or arbitraging”, some would note that the arbitrage could refer to an evolution of ‘non high frequency statistical arbitrage’, others would add latency and rebate arbitrage to the mix. Either way, these are mere high level descriptives and are not representative of what happens underneath; like algorithms it is not the flyer or website description that is key and like many things in life, it is the details and depth that matter. One of those details discussed in more cutting edge circles is the concept of artificial liquidity.

Will, you run a trading desk for a highly respected institutional fund manager; could you talk us through what artificial liquidity is about and how it impacts on you and the market?

Will Psomadelis: Thanks Stuart. Artificial and natural liquidity, being polar opposites in terms of the quality spectrum, are the result of two different strategies and are generally characterised by differing trade durations (or holding periods). Natural liquidity providers are generally investors that deploy capital in the market to extract a return from an underlying business. These include traditional long-only funds, retail, hedge funds and some fundamentally driven quant funds that invest for periods longer than a few minutes.

Artificial liquidity providers (ALPs) ignore company fundamentals and therefore make their decisions on metrics such as price momentum, correlations or by extracting a return through rebates or commissions to name a few. Market maker liquidity is a prime example of this type of churn that is held up as the Holy Grail by some regulators and the one that I believe doesn’t improve our transaction costs. Whilst arguments have been made that the retail investor can benefit from increased churn courtesy of HFT artificial liquidity primarily through tighter spreads, we should remember that no market-wide benefit can be extracted as spread compression is a zero sum game.

It can be then argued that  increased artificial liquidity, which is what we are seeing globally, contributes to the deterioration of price discovery. When market volumes are dominated by trades that have no fundamental basis, stocks can move independently of underlying fundamentals. Empirical evidence shows that stocks now tend to overshoot fundamental news (X.F. Zhang, 2010), ultimately detracting from market efficiency and adding to volatility.

At the institutional order size level, remembering we are really just representing pools of retail investors, we can add to the points discussed above our belief that HFT cannot reduce market impact. The typical institutional order will usually have an order duration of greater than the entire holding duration of a position by a market maker, meaning every trade where we are trading against artificial liquidity, creates a competitor…..

At some point during the duration of the institutional order, the market maker will need to cover their position and therefore compete for stock. This is a real issue when ~70% of volumes are HFT in nature (Tabb Group, 2010 on the US market). Put simply, in the absence of someone willing to withdraw capital from the market at price, it is impossible to inject capital without incurring market impact, even if millions of shares are being churned around you during a game of high frequency ‘pass the parcel’.

The fact that market makers vanish in situations like the Flash Crash and create liquidity vacuums proves that natural investors should not be relying on them for liquidity as liquidity is not really what they provide. Non-predatory artificial liquidity may not necessarily add cost in theory, but it also cannot improve our transaction costs.

MiFID has undoubtedly made its impact on the industry. FIXGlobal collates opinion from Nomura’s Andrew Bowley and BT Global Service’s Chris Pickles on the success of MiFID and its next manifestation.

Having digested the massive changes MIFID brought to the EU two years ago, what has the financial community learnt from the content of MIFID 1 and the process whereby it was developed and implemented?

Andrew Bowley (Nomura):
First and foremost we must conclude that MiFID has worked. We now have genuine competition and higher transparency across Europe.

Costs are down. MTFs (Multilateral Trading Facilities) have brought in cheaper trading rates and simpler cost structures, and most exchanges have followed with substantial fee cuts of their own. Indeed this pattern is also clearly demonstrated by exception. The one country where MiFID has not been properly introduced is Spain and this is one country where fees have effectively been increased. This teaches us that complete implementation is the key and the European Commission needs to look hard at such exceptions.

We have also seen clearing rates reduced, though the fragmentation itself has caused clearing charges to increase as a proportion of trading fees as typically the clearers charge per execution. Interoperability should help address that, assuming a positive outcome of the current regulatory review.

In terms of lessons learnt from the process we must consider that we have experienced a dramatic change in a short period of time, and should allow more time for the market to adjust before fully concluding or looking to further wholesale change. We are certainly still in a period of transition - new MTFs are still launching; and the commercial models of all of these, mean that we are far from the final equilibrium. To have so many loss-making MTFs means that we cannot be considered to be operating in a stable sustainable environment.

Chris Pickles (BT Global Services):
MiFID is a principles-based directive: it doesn’t aim to give detail, but to establish the principles that should be incorporated in national legislation and that should be followed by investment firms (both buy-side and sell-side). Some market participants may have felt that this approach allowed more flexibility, while others wanted to see specific rules for every possible occasion. The European Commission has perhaps taken the best approach by allowing investment firms and regulators to establish themselves what are the best ways of complying with the MiFID principles, and has perhaps “turned the tables” on the professionals. If the European Commission had tried to tell the professionals how to do their job, the industry would have been up in arms. Instead, MiFID says what has to be achieved – best execution. Leaving the details of how to achieve this to the industry means that the industry has to work out how to achieve that result. This takes time, effort and discussion. FIX Protocol Ltd. helped to drive that discussion by jointly creating the “MiFID Joint Working Group” in 2004. And the discussion is still continuing. A key thing that the industry has learned – and continues to learn – is to ask “why”. Huge assumptions existed before MiFID that are now being questioned or proven to be wrong. On-exchange trading doesn’t always produce the best price. Liquidity does not necessarily stick to existing 100% execution venues. Transparency is not sufficient by just looking at on-exchange prices. And the customer is not necessarily receiving “best execution” from today’s execution policy.