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Edouard Vieillefond of Autorité des Marches Financiers looks at the factors that contribute to financial stability and how investor choice needs to be balanced with investor protection, market fairness and efficiency concerns.

FIXGlobal: How can the Commission and the European Securities and Markets Authority (ESMA) ‘encourage’ institutions to trade via multilateral facilities?

Edouard Vieillefond, Autorité des Marches Financiers (AMF):
Market transparency, efficiency and integrity are essential to financial stability and to ensure that financial markets continue to play their core role of financing the real economy.

In the context of the financial crisis, in 2009 the G20 leaders declared that “all standardized over-the-counter (OTC) derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest”. In order to implement these objectives, in 2012 the International Organization of Securities Commissions (IOSCO) identified some key characteristics that electronic trading platforms should fulfil in this context, amongst which were pre- and post-trade transparency and “the opportunity for platform participants to seek liquidity and trade with multiple liquidity providers within a centralised system”. We believe that this multilateral criteria, which is not consensual amongst regulators, is absolutely essential in defining what a trading venue is and ensuring the real efficiency of the price formation process on financial markets.

As regards the perspective of the MiFID review, in Europe the Commission proposes an obligation for derivatives to be traded on multilateral trading venues, which shows progress in the right direction. On cash securities, unregulated trading has developed over recent years, including in the fully OTC bilateral space. The Commission’s aim of catching all these new trading spaces within a new EU regulatory framework is a positive one. However, without clearly defining the boundaries of the European trading environment, it leaves aside the possibility for new trading concepts to be developed, including bilateral ones. It also leaves aside more structural issues – such as the role that we want financial markets to play in the near future with regards to the real economy. An essential first step for legislators and regulators in Europe would therefore be to define in greater detail what the EU trading space shall consist of; and then to incentivize trading of standardized and sufficiently liquid financial instruments on genuine trading venues such as exchanges and multilateral trading facilities (MTF).

FG: Where is the balancing point between investor choice and encouragement towards certain venues?

EV: Investor choice is of course to be kept fully flexible but also, on the regulatory side, to be balanced with investor protection, market fairness and efficiency concerns.

In Europe, MiFID has led to excessive market fragmentation, despite the legitimate intention of the directive to enhance competition between exchanges and multilateral trading facilities. This approach has produced very mixed results, including no real overall cost reduction for final investors, an increase in dark trading and a decrease in the quality of pre- and post-trade transparency to the detriment of the market as a whole.

If financial markets are to remain a reference and to serve investors and the real economy, an essential step in reviewing MiFID is to ensure that orders be primarily executed on genuine trading venues. So, a clear distinction must be made between trading venues where prices are formed according to transparent, non-discretionary and publicly known principles that reflect real supply and demand (exchanges and MTFs), and the other trading spaces. To that extent, it is not possible to consider broker crossing networks (BCNs) and therefore organised trading facilities (OTFs) as equivalent to regulated markets (RMs) and MTFs as they do not offer the same degree of transparency (and hence efficiency) of the price formation process. Crossing networks should at best be considered as an intermediate way to execute transactions, for residual transactions that do not constitute addressable liquidity or with a very strict ceiling above which those BCNs should be transformed into truly multilateral MTFs.

 AXA IM’s Head of Trading, Paul Squires, shares his thoughts on how the buy-side are preparing for MiFID II.

Citi’s Salvador Rodriguez and Daniel Mathews explain how best execution has evolved alongside MiFID and how the latest proposals are likely to affect buy-side and sell-side trading desks.

How is best execution under MiFID II different from MiFID I and from pre-MiFID? Where have we come?

Daniel Mathews, Citi: Although we are referring to MiFID II, we are at the early stages of the MiFID II legislative drafting process. The European Commission (EC) published its proposals last October,T and there will be a number of amendments proposed by the European Parliament over the coming months. The Council of the European Union (EU) will also table amendments and ensuing agreement between the EC, the European Parliament and the Council of the EU (27 member states) will then be required. It is not yet clear what MiFID II and MiFIR will look like in final form as there are a number of key areas which are acknowledged by both sides to need addressing. What is clear is that there will be significant changes to the drafting that is on the table at present.

Salvador Rodriguez, Citi: With the MiFID II process we have seen closer alignment between buy-side and sell-side interests. There is more cooperation between the buy-side and sell-side with a view to what may or may not come out of MiFID II; and this in itself, is a clear improvement from the earlier iterations, which is encouraging for the business at large.

DM: Certainly, the meetings we have had with the buy-side indicate that they are taking far more interest in what MiFID II will mean for them; they want to participate in the debate and are keen to understand what we are doing from a sell-side perspective.

Tools and strategies that have become accepted best execution for many brokers are now under review (e.g. broker crossing and the Systemic Internaliser (SI) regime). How difficult will it be to provide comparable offerings within the SI framework?

DM: One of the current challenges is understanding how the SI regime will operate under Ferber’s proposals and understanding the unintended (or intended) consequences of the amendments, such as ‘all OTC trades must be conducted under the SI regime’. The scope of the SI only extends to liquid stocks, so what happens to non-liquid stocks? Can we trade them outside an SI? Will all risk trades need to be executed within SI and therefore within published firm quotes, even though a risk trades to client may warrant a price outside firm quotes? At the moment, there are many unanswered questions raised from Ferber’s proposals concerning what the SI regime actually means for us and our clients.

SR: As Dan has alluded to, many of the requirements have fallen into the lap of the sell-side. From a trader’s point of view, the tools, strategies and decisions around how to execute a trade will probably not change significantly. Traders will continue to send VWAP or participate with volume-type orders. Naturally, there are pending questions around how risk is employed and whether firm capital can be used within an OTF environment. As a broader business, how clients and orders interact with risk, and how we internalize house flow, are wide-ranging questions. There is no one clear answer; it is a multi-layered problem and there are still grey areas to be resolved.

From which of the MiFID updates will institutional investors notice the biggest change in execution quality and/or strategy?

SR: The MiFID proposals will clearly affect everyone. Under the Commission’s proposals, a BCN would be an OTF and an SI is not a venue. I think this needs to be unpacked. Legally the classifications are fairly clear – you can trade on either a trading venue (RM, MTF, OTF) or OTC and if the latter then to the extent the trading is systematic and frequent then the firm must be an SI. As Dan says though, Ferber’s amendments have muddied the waters so that it’s not clear how an SI is intended to function. Our job is to figure this out through dialogue with our buy-side clients, and we have been seeing many of them recently on market structure road shows, explaining where the current process is at and the areas still to be resolved.

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.

Richard Nelson, Head of EMEA Trading for AllianceBernstein, shares his perspectives on navigating volatility, prospects for developing exchanges, new regulation and the balance between transparency and best execution.

FIXGlobal: How much does volatility affect the way that you trade and what are you using to measure volatility on the desk?

Richard Nelson, AllianceBernsteinRichard Nelson, AllianceBernstein:
We use an implementation shortfall benchmark, so the longer we take to execute an order, the wider the range of possible execution outcomes. Volatility, in particular intraday volatility, increases that potential range, so you could see very good or very poor execution outcomes as a result. In reaction to that, we take a more conservative execution strategy or stretch the order out over a longer time period. And, for instance, if we get a hit on a block crossing network, we will not go in with as large a quantity as we would in a less volatile market. In that way we try to dampen down the potential effects that volatility might have on the execution outcome.

FG: How is AllianceBernstein using technology to improve performance and cut costs on the trading desk?

RN: It plays quite an important part and has done so for quite a while. We are pretty lucky in that we have a team of quant trading analysts. Most of them are in New York, but we have one here on the desk in London, and they help us to analyze the changing market environment and recommend the best ways we can adapt to it. Our usage of electronic trading has increased in the last year, we benefit from the quant trading analysts looking at the results we are achieving with our customized algorithms. We are more confident about getting good consistent execution outcomes because they are monitoring the process and making the necessary changes to ensure the results are what we are expecting. This, in turn, increases the productivity of the traders I have on the desk. They can place their suitable orders into these algorithms and let them run which allows us to focus on trying to get better outcomes on our larger, more liquidity-demanding orders.

On top of that, as market liquidity has dropped significantly, we are trying to make sure we reach as much potential liquidity as possible, and ideally we want to do that under our own name rather than go to a broker who then goes to another venue. We believe that going directly into a pool of liquidity is better done under your own name rather than via a broker because we can then access the ‘meaty’ bits of the pool rather than the ‘froth’. We are looking into ways of doing that but one of the problems is that, potentially, you get a lot of executions from a number of different venues, which results in multiple tickets for settlement. Our goal is to access all these potential liquidity pools, yet also control our ticketing costs, which are a drag on performance for clients.

FG: Was it an intentional change to increase electronic trading or was it a byproduct?

RN: It was a little of both. Our quant trader has been with us for two years and when he first arrived he had to sort out the data issues that exist in Europe and to clean things up. Once the data integrity was sorted out, we looked at different ways of employing quantitative analyses. Having somebody here who is constantly monitoring the execution outcomes means we can proceed down this path with real confidence. As a London firm, we were a little behind in our adoption of electronic trading, but now we are in the middle of the pack in terms of usage. It makes sense from a business and productivity perspective that there are many orders that do not need human oversight, which are best done in algorithms.

Steve Grob of Fidessa explains how brokers, traders and exchanges can adapt to life under MiFID II.

If MiFID II increases regulation on broker crossing networks, what other options do brokers have to trade with minimal market impact?

It depends upon the shape any such regulation takes. It looks likely that MiFID II will introduce a new category of ‘venue’ called an OTF - or Organized Trading Facility - that will be used to describe Broker Crossing Networks (BCNs). This will help the market as a whole as it differentiates the client crossing activity of brokers from their other, discretionary, activities. In this latter case the broker is fulfilling its fiduciary duty to its client in other ways such as by risking its own capital in order to complete a client order. This is a completely different activity from the quasi ‘venue-like’ matching of two different client orders electronically.

BCNs are part of the non-lit trading category that also includes buy-side crossing networks such as Liquidnet, dark Multilateral Trading Facilities (MTFs), such as Chi-Delta or  SmartPool, and bilateral Over-the Counter trading. Unfortunately, all of these very different activities are sometimes lumped together as ‘dark’ trading. The lack of clarity around non-lit trading is the cause of much confusion amongst the regulators, some of whom seem to think that all ‘dark’ trading is somehow bad, however, trading away from an exchange is often the only way that many investment firms can achieve their objectives without undue information leakage or price slippage.

What is really needed is a clear description of each of these non-lit categories so that traders know what they are getting into, how deep the water is and who else they might be  swimming with. In this way, the investment community is free to choose the best way of completing its orders.

Where is the biggest opportunity for banks in this new round of regulation? How can European banks come out ahead from this, or is it a question of losing the least?

The banks have suffered as much as any other market participants. In particular, the lack of a clear consolidated record of post-trade information has made it harder for them to prove the efficacy of the millions of pounds they have invested in technology to help their clients navigate the new post-MiFID liquidity. Clearer reporting rules will also make it  easier for them to rebuff the politically motivated criticism they have faced.

What role will technology have in ameliorating the effects of MiFID II? What solutions should firms consider in order to better cope with the shift toward lit venues and transparency?

Technology has and will continue to play a huge part in all this. One of the trends we are seeing is a convergence between algorithmic trading and Smart Order Routing (SOR) so that the process of deciding how to trade gets combined with where to trade. On top of this we are also seeing a greater propensity for the buy-side to fly these hybrid algos  remotely.

How can European high frequency proprietary traders remain competitive if they are required to undergo public scrutiny regarding their algos and strategies?

The High Frequency Trading (HFT) community would certainly find life difficult if its algos and strategies were open to public scrutiny, although this would seem to be an unlikely outcome. Given that HFT represents such a significant proportion of European (and US) volumes it would be an incredibly brave move if the regulators sought to censor them in such a heavy-handed manner. In many cases, the HFT community is simply acting as electronic market makers and actually are increasing liquidity and reducing risk in markets. This is because they act as sellers when there are no natural buyers and vice versa. On the other hand, there is a perceived concern over what can happen to markets if their algos go wrong or misfire. The first people to suffer in any such eventuality, though, are the HFT firms themselves, so it is not in their interest to be careless in this area.

Nevertheless, mistakes can happen and most HFT firms would accept the idea ofcircuit breakers being introduced at the exchange level. This is where the ‘fuse box’ needs to be and it is right that the exchanges bear the cost of this as they are the ones making money selling space to the HFT players in their co-location centres. Ultimately, the responsibility for maintaining an orderly market must rest with the venue rather than the participants. If they build faster and faster racing tracks, then they surely have a responsibility to erect and maintain suitable crash barriers.