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.
When 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.
Matteo Cassina of Citadel Execution Services Europe comments on the development of a European consolidated tape as well as a unified concept of best execution.
The long awaited proposals on the review of the Markets in Financial Instruments Directive (MiFID) were published in October 2011. The so-called MiFID II and MiFIR proposals aim to address, among other things, changes in the European market structure and competition between trading venues. Whilst the proposals, in their current form, do not provide as much detail as market participants had hoped, they represent a unique opportunity to address fundamental issues impacting the efficient functioning of Europe’s equity markets.
The EU legislative process is such that the European Parliament and the European Council will agree their negotiating positions, before embarking on a trialogue process mediated by the European Commission. The final legislative text may not be ready for implementation until as late as 2014, but this timeframe represents a good opportunity for the rules and their impact to be given adequate consideration. In particular, the issues of best execution and consolidated tape need to be given greater prominence during this review process, if policymakers are to honour the original objectives of MiFID, protect the retail investor and ensure Europe’s equity markets become efficient and competitive.
A key benefit of regulation is that it drives standardization of behaviour but thus far, this has not materialised (in the retail broker community in relation to best execution requirements). Large institutions have the capabilities to take advantage of the proliferation of alternative trading venues and are benefitting from cost reductions by being able to execute their orders in the venue which offers the lowest price for a security at a given time. The majority of retail investors, however, are still either unaware of, or do not have, the opportunity to access alternative trading venues. This means they do not always benefit from prices equal to, or better than, those available in primary venues.
While the principle of best execution is reiterated in MIFID II, it is not included in MIFIR which means that — once again — best execution is a principle, not a rule and therefore open to interpretation at the national level. This is in stark contrast to the best execution model in the US, where the requirements to achieve best execution are much more stringent. Currently, a retail broker in Europe can chose to route all of its trading to one single venue, on the basis that it has a good commercial relationship with that venue, or that it is too costly for the broker to connect to multiple venues. The broker may choose to send all orders to a venue with the highest chance of getting the best price, without necessarily guaranteeing that it is the best price at that moment in time. This is an unfair outcome for the retail investor and MiFID II/ MiFIR proposals, regrettably, do not go far enough to redress this.
Enforcing best execution will take time and will depend on broader market harmonization, but now is the time for regulators and retail investors to demand a more compelling definition of best execution. In particular, greater clarity is required around the execution policies provided by retail brokers to their clients. These policies are documents in which retail brokers explain how their best execution obligations are fulfilled under MiFID. Trading venues and brokers should also be required to provide execution quality statistics, detailing how well they performed in achieving best execution. This much needed clarity would, for example, result in firms having to justify — to both regulators and clients — why certain trading platforms are listed on their best execution policy and, why others have been omitted. In short, how and why some orders are routed to specific venues and not to those with the best price.
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.
PJ Di Giammarino, CEO of the JWG Group examines the goals of the European Consolidated Tape and suggests what needs to be done by banks and regulators to reach a consensus.
The notion of having a “system of record for the market,” is central to the regulatory reform efforts. Is MiFID back where it started? Where are we in this saga and why should both the buy-side and sell-side care? The recent MiFID review was initially going to entail only a few minor technical revisions to the active directive; no one was particularly worried about it. In one of 2010’s biggest surprises, the review snowballed, expanding the scope and depth of change dramatically. In its current form, the MiFID review represents a massive shift in the way financial markets operate in Europe far exceeding the original implementation, as evidenced by its expansion into commodity price controls. In many ways, this ‘review’ has the industry right back to where we were in 2005 – attempting to figure out what transparency means to ‘business as usual’. So what is different this time?
Perhaps the big differences are that 1) the stakes are far higher; 2) Europe is no longer alone, and 3) there is real resource to get it right and, therefore, add value to the industry. Across the world, supervisors are worried about the completeness of their view of the financial markets, as well as establishing a level playing field for market participants. New data requests are the order of the day, originating from every part of the value chain and generated by the hedge fund directive (AIFMD), OTC derivative reporting to trade repositories, short selling transparency and the SEC’s Large Trader Reporting System. Meanwhile, regulators are also calling for more transparency back to the market, shedding light into dark pools by forcing real-time (or close to realtime) post-trade data and introducing new post-trade transparency regimes for entire asset classes, such as bonds and derivatives.
Why does the creation of a European Consolidated Tape – a discussion that was successfully batted away by the industry in 2004 – now matter? What is the real driver for it? Clearly, buy-side firms feel it is difficult to acquire a complete view at a reasonable cost and would welcome the initiative. The public can see the point. If market participants cannot reasonably afford sufficient pre and post-trade data for their needs, they are unfairly disadvantaged.
Though many larger firms are happy with the ‘status quo’, this is a particular problem in Europe, where an ever-more fragmented market means that a full set of equity market data costs approximately €450, as opposed to €50 in the US, according to consultation responses. By lowering these costs, regulators say investor protection will be enhanced and price discovery will be facilitated more easily. The real question, however, comes down to whether the tape will be of value to market practitioners, and the answer, as ever, depends on ‘the how.’ The discussion in the European Commission is not on whether a consolidated tape is necessary, but how it should work and who should run it. The bottom line is that, if the tape is done correctly, it will have huge knock-on benefits to the cost/income ratio and be used to build products nd services that can bring value to market participants and regulators.
Smart vendors are seizing the consolidated tape as a commercial weapon. If one company can grab sufficient market share for the tape, the value-added data and services that could be offered would be both attractive and lucrative. Therefore, the industry ought to officially open the discussion to vendors early to start helping with the requirements, operating model and commercial terms. The industry has so far failed to define the detailed ‘rulebook’ and standards required to be able to create such a system of record; hence, the well-known arguments about the quality of the data amongst the many players involved.
So can the industry define ‘what good looks like’ and fix the system? We think the answer is “yes” – but we need the banks to focus on the issues in the centre and commit to solving them. A few meetings instigated by CESR last summer were able to produce the type of quality standards effort from industry practitioners that has been missing in the five years of MiFID’s history. If the industry wants to create, publish and maintain a way to consolidate the trading across Europe, it can. And, for a variety of reasons, it should.
Of course, we cannot fall into the trap of assuming what works for apples will work for pears. The unintended consequences of getting this wrong could be huge; market liquidity is not something to alter without understanding the potential impact thoroughly. Regardless of the scope, timing, operational date or any other considerations the EC has on the table, the consolidated tape will become a reality in one form or another. Rulebooks, standards and quality measures will be written by the regulators, whether we like it or not. The information will be usable by the market and the supervisors, not only to fulfil their remit of market protection, but to challenge trading practices, adjust capital and liquidity buffers and seek out and identify systemic risk.
Deutsche Bank’s Stephen McGoldrick underscores the complexity of the MiFID Review proposals for trade delay reporting and minimum order size and suggests a way forward.
MiFID Review: An equity market fit for all?
Deutsche Bank recently responded to the European Commission’s Consultation on the MiFID Review. While there is much to applaud in the proposals, the bank made it clear that we are concerned about some of the detailed proposals and, perhaps, more concerned about the lack of both detail and justification provided for others.
Protecting All Retail Investors: Not just the wealthy
The consultation process has raised a fundamental concern around what the review is seeking to achieve. Policy makers want, to varying degrees, to increase investor protection and the orderliness, stability and efficiency of the market. It is an unfortunate truth that the promotion of one of those goals may be at the expense of another. There will be trade offs the regulators are willing to make, but knowingly providing investor protection for a small group of retail investors at the expense of a larger less wealthy group of individuals is surely not one of them. Yet, by designing a market structure to serve those who are investing in the markets directly, the regulators may reduce the returns of the millions of individuals who invest via collective pension and saving schemes. The interests of retail investors must be protected explicitly and carefully, and doing so includes providing them with efficient markets that can handle their order profile.
Somewhere, however, we seem to have lost sight of the fact that “retail flow” (i.e those small orders sent to the market by private individuals) accounts for a tiny proportion of the flow from retail investors. Most individuals investing in equities access the market collectively. Equity markets could, in theory, be optimised for retail flow but we believe that serving the relatively low numbers of individuals who have enough time and wealth to speculate directly in the market, at the expense of the far larger numbers who rely upon the wholesale market to manage their investments, would be a gross disservice to those prudent enough to save and cautious enough to do so via investment managers.
Trade Reporting Delay Proposal: Harming the retail saver
It is a broadly accepted principle of equity markets that, in general, trades should “print” as soon as possible to help inform the price formation process. There is also a broadly accepted exception to this principle, namely that the reporting of the largest of wholesale trades should, under certain circumstances, be delayed. However, it is proposed that both the duration of such delays and the number of orders qualifying for them should be massively reduced. The only rationale for these changes that we can find in the Consultation Paper is the truism that it “would help to make post trade information available sooner to the market”. Although it would, to many market practitioners it is equally clear that it would also reduce the investment returns of collective retail investors, while increasing the cost of capital for the Small-Medium Enterprise sector that so much else of the proposals rightly seek to support.
So why might a European Member of Parliament support this proposal? It appears that the desire to achieve a level playing field between individual retail investors and collective retail investors has led some to the view that if delays are of no benefit to the former, they should be denied to the latter. The irony is that the harm done to the returns of collective investment schemes by these proposals would not benefit individual retail investors, but rather the lost returns would be collected by high frequency strategies run by market professionals that seek to trade ahead of large orders.
Minimum Order Size: A Counterproposal
The review proposes to have a minimum order size in dark pools. We can see no benefit and multiple disadvantages to this proposal, and as no benefit is described in the European Commission’s consultation paper, we cannot comment on whether it would be an effective means of achieving the underlying policy objective. Such a change should not be made unless there is a “greater good” that justifies both the loss of price improvements that the retail investors currently accessing these pools would suffer and the commercial advantage that such a proposal would bring to the operators of lit books to the detriment of the operators of dark books. A better proposal would be to protect retail investors from the harm done to the market by large investors trading in an unnecessarily small size in all pools. If artificially small orders are prohibited by regulators, they will be promoting improved efficiency, market orderliness and price formation.
In this article, Nomura’s Ben Springett provides a brief overview of some of the key issues currently impacting European market structure, and shares his own thoughts on some of the changes likely to occur in Europe this year.
European market structure, has been, is, and will continue to be, in a state of change for the foreseeable future. Whilst European Commission regulation has been a significant catalyst in this, the industry itself is now looking to progress issues at a faster rate than the expected regulatory change. As such we are seeing increased interest in “self” regulation within the community, particularly in the areas of post trade reporting and efforts to provide a consolidated tape. All market participants are active in this, but it is not unreasonable to assume that it will be down to the broker-dealers to drive any change, as they typically are the ones that have the resources to invest in the process.
Market share amongst trading venues can be measured in many different ways and people can be forgiven from choosing one that paints their own venue in the best light. The accompanying two charts (Charts 1 and 2) show the steady decline of market share amongst the key primary exchanges, to the benefit of the MTF venues, although the total volume levels remain significantly lower than the pre-credit crunch days. When considering primary exchange volumes versus MTFs it is necessary to bear in mind that the primaries are only just starting to compete in each other’s markets, and as such the pan- European MTFs have had more blue chip names with which to capture their market share. This is set to change in 2010; Euronext launched ARCA last year, Xetra have launched their International Market (XIM) and the London Stock Exchange (LSE) have just completed the acquisition of a majority (51%) stake in Turquoise.
MiFID did not mandate a market- wide consolidated tape, as opposed to the NBBO ( National Best Bid and Offer) provided under Reg NMS, and the lack thereof is one of the key concerns raised by the buy-side in a range of forums. There is however, no significant issue with data aggregation offered by a number of key providers such as Bloomberg and Reuters; in addition to some strong fragmentation analysis products available to the market (Fidessa Fragulator, BATS Europe).
In a period of time where cost base is under increasing pressure, attention has now been drawn to the inherent impenetrable conditions that exist in market data (the LSE has sole distribution rights on LSE data, Deutsche Boerse on Deutsche Boerse data etc.), and as the number of venues from which the data is required for increases, so will the interest placed on the associated charges. In an environment with considerable focus on competition, competitive forces cannot work to reduce the fees, leaving regulation as the only option, which was again addressed under Reg NMS in the US.