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?
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.
FG: What essential characteristics does a European consolidated tape need to be effective?
EV: The implementation of MiFID resulted in a fragmented and less transparent trading universe, in terms of liquidity as well as information. After having left data consolidation to market forces without any visible result, legislative action is now required to cope with these drawbacks and the revision of the directive is an opportunity not to be missed.
Creating a viable consolidated tape (CT) in Europe is key to determining a price of reference for duly applying best execution rules, or proper circuit breakers on all trading venues. The European Commission proposes the creation of a CT provider status, in charge of ensuring the consolidation of post-trade data. However, the model does not require that the information provided is exhaustive. It does not guarantee the consolidation by a single body of all the transaction data in a specific financial instrument, therefore it will only partially remedy the current fragmentation of information.
A European consolidated tape must be centralized and comprehensive in order to fully consolidate information and be effective, with strong involvement from market authorities and ESMA. As a minimum, there should be one tape that consolidates all post-trade data on transactions made in a financial instrument in the various trading spaces (exchanges, MTF, OTF and OTC). It is necessary to supervise the creation and operation of a single comprehensive consolidated tape for equities, through minimum specifications established by public authorities.
FG: Is there a model that the Commission should consider for pan-European circuit breakers and algorithmic monitoring?
EV: In Europe, the MiFID review is an opportunity to tackle the issues raised by the rapidly evolving market technology and the European Commission’s text proposals are to be welcomed in this field: they rightly frame the systems and controls to be put in place in an automated trading environment, as well as foresee tools required to intervene further on the market structure. In particular, it is important for the regulators to gain access on request to all meaningful information on the trading algorithms used by market participants.
In order to create a comprehensive regulatory framework to ensure market efficiency and enhance investor protection, ESMA has a key role to play in fixing parameters such asthe tick size and fees paid by every market participant for each order modification or cancellation – matters that will be best dealt with through binding technical standards, in close consultation with the industry.
Regarding circuit breakers, reaching a certain level of harmonisation amongst trading venues is important, even though regional and local triggering events must be distinguished. The optimal solution would be to have a common reference price on the basis of which static circuit breakers would be determined, to be enforced on all trading venues.
FG: Why is it essential that third party countries have access to the European financial system and vice versa?
EV: Cross-border financial flows are vital – not only within the European single market – but also between Europe and other major financial centres. European businesses need access to capital and the services provided by third country firms. We do not support protectionist reflexes. On the contrary, we aim to encourage competition, but this must take place on a level playing field, which requires clarification and harmonization of the conditions to be met by third country firms in order to access EU investors.
The rules governing access of third country investment firms to European investors are highly fragmented because MiFID I provides for national discretion in this area. These divergences raise concerns for the single market, lead to increased costs for third country firms and create considerable legal uncertainty. At the same time, under the impetus of the G20, FSB and IOSCO, international convergence is moving forward. We therefore believe it is necessary to harmonise requirements in the EU, and to avoid both gaps and overlaps in the treatment of third country firms.
The CRA Regulation and the AIFM Directive, as well as the European Market Infrastructure Regulation (EMIR), have included provisions on third country entities. We broadly support the Commission’s proposal to introduce a third country regime under MiFID II. The regime would be based on an equivalence assessment by the Commission of each relevant third country regime and the development of appropriate co-operation arrangements between EU and third country regulators.
The third county regime proposed by the Commission would be calibrated in order to take into account the level of sophistication of EU clients and to avoid unnecessarily restricting investment opportunities for them. This regime should only target professional investors, not retail.
Overall, these proposals appear balanced and reasonable. We would, however, suggest that a formal role be attributed to ESMA in the equivalence assessment, and that some services such as the management of a trading platform or the holding of client assets should always be provided either through an EU subsidiary or an EU branch.
Financial Services Authority’s David Lawton talks about how to reduce systemic risk in the markets and how to introduce stability.
FIXGlobal: What unique role do UK markets play in the larger European trading arena and to what extent should that be protected?
The UK is the predominant location for wholesale financial market activity in the EU. Providers based in the UK play a significant role in assisting commercial firms across the EU to finance themselves and manage the risks to which they are exposed.
Against that background therefore, there needs to be a continuing focus on raising the competitiveness of the EU as a location for financial services through efforts to improve the functioning of the single market in financial services. A more effective and well-regulated single market will benefit the EU as a whole as well as offering opportunities for the UK to continue to grow as a major international financial centre doing business across the EU and further afield.
FG: How will the Legal Entity Identifiers (LEI) system reduce systemic risk in the market? How specifically does this mode of transparency improve stability?
DL: The LEI will help improve financial stability in two main ways. The first is by enhancing the ability of regulators to use data from financial institutions and from trade repositories, and to aggregate data across trade repositories. Regulators will be better able to detect build ups of counterparty exposures and other risks and take steps to control them. The second main benefit from a global LEI system will be an improvement in firms’ own risk management, as they will be better able to aggregate their own exposures across the institution and more accurately identify their largest or riskiest counterparty exposures.
FG: If organized trading facilities (OTFs) rely on conflict management processes instead of a ban on operators trading their own capital, how stringent do they need to be to meet the Commission’s goals for market stability?
DL: The Commission’s stated objective in preventing the operator of an OTF from crossing client orders against their own proprietary capital is operator neutrality. The potential for conflicts of interest arise in any trading system where the operator is allowed to participate, including in systems regulated as multilateral trading facilities (MTFs), and so this is not a new problem.
In the UK, conflicts of interest management procedures, in line with the Commission’s proposed MiFID Article 19(3), have been used effectively on MTFs operated by investment firms to mitigate the potential risks whilst allowing the benefits of the liquidity provided by the MTF operator. Such procedures include operational segregation between the MTF operation and the firm’s proprietary trading desk. We believe that an entirely similar regime for OTFs would achieve the goal of operator neutrality whilst providing liquidity for the facilitation of trades – which is all the more important in the less liquid, non-equity instruments that are likely to trade on OTFs.
FG: What essential characteristics make over-the-counter (OTC) pre-trade requirements potentially harmful to normal market operations?
DL: The current MiFID proposals will introduce mandatory pretrade transparency into non-equity markets that are currently traded OTC, in the context of creating the new category of Organized Trading Venue, and expanding the scope of the current Systematic Internalizer (SI) regime. Greater pre-trade transparency is welcome, but it will be important that the detailed approaches take account of the nature of trading in less liquid instruments.
The current market structure for bonds and derivatives trading is essentially two markets: the dealer-to-client market (where dealers trade with corporates, investment funds and other endusers), and the inter-dealer market (where dealers hedge the trades they have made with their clients and rebalance their inventories). When a dealer trades with a client, they typically then enter the inter-dealer market to hedge or rebalance their own inventory position. Consequently, there will be a period during which the dealer holds risk on their own balance sheet. If the dealer’s quotes are required to be publicly displayed, then other dealers may observe these quotes and adopt countervailing positions in the inter-dealer market in order to benefit from the inevitable hedging activity the quoting dealer will undertake. It therefore becomes more risky and expensive for dealers to ‘make markets’. The potential result is some combination of reduced liquidity provision and worse prices for end users.
The other key consideration is the nature of the trading systems that are likely to be used for trading such instruments – namely the voice broking and hybrid voice/electronic platforms. It is important that pretrade transparency requirements take into account the specifics of the market model, allowing such systems to continue to operate, benefitting users and ultimately the real economy.
FG: Why is it essential for the UK and Europe for third party countries to have access to the European financial system and vice versa?
DL: Europe cannot be an international financial services centre if it is not open to business with the rest of the world. For example, EU investment management firms will not be able to compete properly if they cannot access research and execution services across the globe when managing funds that are invested across the globe. EU firms must also be able to assist in meeting the funding and risk management needs of commercial firms based in the world’s fastest growing economies of Asia, Africa and South America. In addition, European issuers and investors must be allowed to benefit from the competitive pressures that flow from the EU being open to financial services providers from outside the EU.