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.
Simo Puhakka, Head of Trading for Pohjola Asset Management, shares his experience trading in the Nordic markets, giving his opinions on interacting with HFT, using TCA and knowing whether you can trust your broker.
The prospects for High Frequency Trading (HFT) are really up to regulators. It will be a free market, but as we all know, regulatory changes affect the whole trading landscape. For example, we can see what is happening in France and the debate that is going on in Sweden, which are quite hostile towards HFT, so those countries.
Personally, I think that HFT is a good thing for the market, as long as you have the proper tools to deal with it. There are a number of small firms that have been suffering from HFT
since MiFID I because they lack the proper technology and tools to measure and deal with it. We have not suffered in our dealings with HFT, and I would actually say in many cases, it is the opposite. HFT firms seem to add liquidity and when you have the proper tools to deal with it, you can take advantage of it.
Speaking of tools, we started building our own Smart Order Router (SOR ) a year and a half ago. The goal was to create an un-conflicted way to interact with the aggregated liquidity. In this process we went quite deep into the data and turned processes upside-down with the result that we have full control of how we interact with the market.
On the other hand, I welcome technological innovation from the sell-side; for example, brokers now disclose the venues where they execute trades on an annual basis. The surveillance responsibilities that brokers have are beneficial. Many of the small, local brokers and buy-sides, however, are now finding it challenging to upgrade their technology.
Trusting your Broker
Our approach was to take control of our order flow and only use our brokers for sponsored access. We chose full control because, in some to deliver what I am asking.These questions first arose a few years ago, and we realized we needed to create a transparent, fully-controlled, non-conflicted path to the market. How you interact with different venues – even lit venues, where you have more transparency – will affect your choice of strategy. In most cases, you are better off without brokers making decisions for you. The root of the problem is, when you send an order to the broker, what happens before it goes to the venue? What control do we have over the broker infrastructure, including their proprietary flow, internalization, market making and crossing, not to mention the routing logic?
When we dug into the data, we were quite surprised to see that, although a broker was connected to all the dark liquidity, many of the fills were coming from that particular broker’s dark pool, suggesting there are preferences in the routing logic. Brokers want to internalize flow, which is not a problem, if you are aware of potentially higher opportunity costs. When it comes to dark liquidity, that is an even bigger problem, since our trades were often routed to the broker’s own dark pool or those it has arrangements with.
When I accepted a job in the Indian financial markets six months ago, my thinking was simple. First, I believed (and still believe) that India has an once-in-a-lifetime opportunity to pull away from the pack and establish itself as the largest and most dynamic financial market in Asia. Second, I thought I could contribute to the efforts of my new employer to compete more effectively and grow its business.
I expected to draw on my experience working at and for exchanges in the US and Asia for more than two decades. I also expected to draw upon my training in finance and economics. What I did not expect, was that I would find myself regularly reaching back to wisdom and inspiration from books I had read in college – particularly the inspiration and observations of US revolutionaries and civil rights heroes. Let me explain.
From most perspectives, the opportunity in Indian financial markets today is spectacular. There is the confluence of factors that – unless some or all of them are seriously derailed – will allow Mumbai to emerge as a major global financial center.
First, India has the virtue of a large domestic market. In Asia, this gives China and India, a big advantage over Singapore and Hong Kong, today’s front-runners in the race to become Asian Financial Centers.
Second, the Indian economy is growing rapidly and this growth, because of India’s early stage of development, is likely to continue in the 6-8% range, and quite possibly the 8-10% range, for the next decade. Even if the size of India’s financial sector relative to GDP stays constant, it will double in absolute terms over the next decade, assuming 7% growth. A much more likely scenario, however, is that we will see dramatic financial deepening in India over this time period.
Third, India already has much of the basic financial market infrastructure in place. Admittedly, there are a few gaps – such as a vibrant “Stock Borrowing and Lending” market. And there is always room for improvement – especially when it comes to coming more into line with global best practices and standards. But, most would agree that India’s financial market “plumbing” is working well. In terms of trade processing in the equities market, for example, Indian exchanges match, clear and settle a phenomenal number of transactions each day – putting both BSE and NSE easily in the top ten globally.
Fourth, India has a reasonably effective and transparent regulatory environment – focused on investor protection and market development. Regulators are appropriately cautious in some areas. The focus has been on risk management and the gradual introduction of new products. This has generated some frustration at times for market participants who want regulatory changes to come more quickly. But, by and large regulations are evolving well, taking into account the views of the market, international practices and Indian ground realities.
Fifth, Indian financial markets are quite open to foreign participation. While there are some notable impediments — for example, restrictions on foreign retail investors – it remains true that offshore participation by foreign institutional investors (FIIs) is substantial. More significantly, if a foreign securities firm wishes to come “onshore” in India, it is to a very large extent free to compete with domestic firms. The benefits from this foreign participation, in my view, have been substantial, bringing global practices, global talent (much of it Indians working at foreign firms), and global competition into the market.
Sixth — and most relevant to my comments here – India has a competitive exchange environment that will be a critical factor in lowering trading costs, increasing liquidity and driving the development of the markets through innovation.