Chiming KAM[1]
Introduction
The European MiFID legislation[2] has successfully put an end to the monopoly of regulated markets (RM) with the introduction of multilateral trading facilities (MTF) in the trade execution business. To make markets more transparent, the new MiFID 2/MiFIR package[3] also adds a new category of trading venue, the organised trading facility (OTF)[4]. Yet, there have been intense lobbying efforts from exchanges to kill the OTF proposal, arguing that adding more venues would fragment markets needlessly[5]. However, the European institutions strongly resisted with the support of inter-dealer brokers, justifying the necessity to bring more OTC (over-the-counter, i.e. privately negotiated between the parties) derivatives’ trading onto regulated exchanges.
At the heart of the rationale for creating OTFs is that the development of BCNs (broker-crossing networks) and dark pools were meant to evade the pre-trade transparency requirements under MiFID. Put simply, those arrangements are automated systems that match buying and selling interests for financial instruments outside any regulatory obligations. This clearly impairs the adequate level of transparency that could be reasonably expected by investors. MiFID 2 then aims at closing BCNs out of equity trading and driving all equity and OTC derivatives’ trading onto regulated trading venues or transparent execution towards systematic internalisers. As a result, a BCN must either become an MTF if it wishes to continue to internally match orders or, more drastically, exit the business.
The OTF is thus meant to bring those arrangements within the scope of MiFID 2. The definition is purposely broad “so that now and in the future it should be able to capture all types of organised execution and arranging of trading which do not correspond to the functionalities or regulatory specifications of existing venues”[6]. Pursuant to article 4(1)(23) of the MiFID 2 Directive, the OTF is defined as “a multilateral system which is not a regulated market or an MTF and in which multiple third-party buying and selling interests in bonds, structured finance products, emission allowances or derivatives are able to interact in the system in a way that results in a contract”. Under this definition, one can read that OTFs are only applicable to non-equity products and that the “execution of orders is carried out on a discretionary basis”[7], as opposed to RMs and MTFs. If OTFs constitute a multilateral trading venue, they do not share many common features with the latter.
The multilateral feature of the OTF is of particular interest and is the main focus of this article, which will further attempt to explain that this new trading venue is situated in a grey area between the multilateral and the bilateral worlds.
Multilateral vs. bilateral: the discretion paradox
MiFID 2 qualifies the OTF as a multilateral trading system[8]. A multilateral market is “a setting whereby a market operator or an investment firm operates as riskless and neutral counterparty, which brings together on a systematic basis all sorts of buying and selling interests[9].” “Riskless” because the trading venue cannot match orders against proprietary capital, i.e. it does not trade on its own account. It is “neutral” because the venue does not exercise any discretion on the matching of orders and the access to the platform. Should one of these two requirements not be met, the system will be deemed to function on a bilateral basis, i.e. outside any formal exchange.
Yet, it does not seem that those features comply with the OTF definition. As regards the power of discretion, though limited, the OTF may use the latter when executing orders[10] as opposed to RMs and MTFs. This exercise of discretion is twofold, which places the OTF in a grey area, somewhere in-between the multilateral and the bilateral areas.
First, the OTF operator is able to exercise discretion when deciding to place an order on the OTF or to retract it, i.e. it may decide when and how much of two or more orders it wants to match within the system. It also decides to route orders to other venues. In addition, the operator that arranges transactions may facilitate negotiation between clients so as to bring together two or more potentially compatible trading interests. Nevertheless, regulators may require, during the authorisation stage or on an ad hoc basis, a detailed description of how discretion will be exercised, particularly regarding when an order may be retracted and how client orders are to be matched[11].
Second, it may also decide not to match a specific order with the orders available in the system at a given time, provided that the decision complies with the client’s instructions and the best execution obligation. This discretion definitely constitutes an element of difference between the other multilateral trading venues where discretion is impossible. However, like RMs and MTFs, the access to this system must be based on transparent and non-discriminatory rules[12].
As mentioned earlier, the general principle is that multilateral systems are not allowed to execute client orders against proprietary capital, i.e. using own account[13]. Of course, OTFs are subject to this prohibition. There are nevertheless two exceptions, which drive this trading venue further away from the multilateral systems.
The illiquid market for sovereign debt instruments’ concession
The first exception relates to the sovereign debt instruments’ market, i.e. bonds issued by member states. Article 20(3) of the MiFID 2 allows the investment firm or the market operator of an OTF to engage in dealing on own account with regard to sovereign debt instruments for which there is not a liquid market. This obviously challenges the multilateral feature of this trading venue. This exception has been demanded by the member states in order to facilitate the financing of their public policies. But one may wonder what an illiquid market of sovereign debt instruments really is, for the purpose of allowing OTFs to deal on own account.
While MiFID 2 and MiFIR provide for a definition of a liquid market[14], there is no provision that defines a “market which is not liquid”. Level 2 provisions have been drafted by the European Securities Market Authority, via a draft regulatory technical standard, to specify the notion of a sovereign bond for which there is not a liquid market but for transparency purposes only[15]. Indeed, the legal basis for this definition, i.e. article 13(8) of the draft delegated regulation[16], refers to transparency calculations and cannot be used to determine whether an OTF can deal on own account. This is disconcerting because there are two different definitions of a liquid market. It is not hard to see that this issue is political, which may lead to an unlevelled playing field at the expense of investors, thus weakening the harmonisation objective of MiFID 2. In fact, this means that member states have a margin of appreciation of what constitutes a liquid market for sovereign debt instruments in order to allow an OTF to trade on own account. One may reasonably expect that they would be in favour of supporting liquidity in the sovereign debts’ market; they would presumably set up a low threshold to consider a sovereign bond to have a market which is not liquid.
The matched principal trading exception
The second exception to the prohibition of own account trading lies in the OTF’s ability to use matched principal trading (MPT). There are two conditions: the client must consent to it[17] and orders must be related to bonds, structured products, emission allowances and derivatives; except for those that are subject to the central clearing obligation in accordance with the European Market Infrastructure Regulation (EMIR). In practice, the client’s consent would be easily obtained through the OTFs’ terms of business but it remains to be seen whether regulators would be better satisfied with a more explicit form of consent[18].
MPT is defined in article 4(1)(18) as “a transaction where the facilitator interposes itself between the buyer and the seller to the transaction in such a way that it is never exposed to market risk throughout the execution of the transaction, with both sides executed simultaneously, and where the transaction is concluded at a price where the facilitator makes no profit or loss, other than a previously disclosed commission, fee or charge for the transaction”. Simply put, an intermediary stands between two counterparties to match orders by simultaneously arranging offsetting trades using their own money, without taking any market risk. The definition is wilfully narrow and seems to leave no room for any form of proprietary trading, notably because of the prohibited profit-making from using MPT.
Policymakers, notably the EU Commission feared this risk. However, market participants such as inter-dealer brokers have successfully lobbied to benefit from this method of trade execution, arguing that they play a significant role in providing liquidity in the debt instruments’ market. As for RMs and MTFs, matched principal trading is prohibited, which is another element that distinguishes the OTF from them, thus switching softly towards the bilateral side. It seems that an OTF is not so multilateral after all.
Conclusion
As outlined above, the OTF appears to borrow some features of a bilateral venue, albeit being classed as a multilateral one. The aim is to strengthen transparency by bringing off-regulated trades to official venues and liquidity, especially in strategic areas like the sovereign bonds’ markets. While the prospective additional provision of liquidity may incentivise clients to trade on an OTF, it remains to be seen whether it will be a success. Of course, the ability to apply discretion, use own money in a specific circumstance, or the use of MPT are all advantages that might be enough for investment firms to seek a license to operate an OTF. Yet, MiFID 2 does come with additional investors’ protection requirements and the significant compliance cost might deter them to enter the business. Even before the delayed application of MiFID 2 (due on 3 January 2018[19]), some authors have already argued that the OTF will not fix the weaknesses of the previous MiFID legislation because of the exclusion of equity in the OTF category and the conservation of pre-trade transparency exemptions[20]. They may be right, but only time will tell.
[1] LL.M, King’s College London; Master’s Degree, University of Cergy-Pontoise
[2] Directive 2004/39/EC of the European Parliament and of the Council of 21 April 2004 on markets in financial instruments
[3] Directive 2014/65/EU of the European Parliament and of the Council of 15 May 2014 on markets in financial instruments and Regulation (EU) No 600/2014 of the European Parliament and of the Council of 15 May 2014 on markets in financial instruments
[4] Operating an OTF is an investment service in accordance with Annex 1, Section A, (9), MiFID 2. The operator or the investment firm must then be licensed to operate an OTF.
[5] J. Grant, « Key Brussels Mifid regulator to move jobs”, Financial Times, 4th January 2012, last accessed 12 February 2016.
[6] Recital 8, MiFIR
[7] Article 20(6), MiFID 2
[8] Article 18(7), MiFID 2
[9] D. Valiante, “Setting an institutional and regulatory framework for trading platforms”, (2013) JFRC 21(1), 69-83, 1 February 2013
[10] Article 20(6), MiFID 2
[11] Article 20(7), MiFID 2
[12] Article 18(3), MiFID 2
[13] Article 47(2), MiFID 2
[14] Article 4(1)(25), MiFID 2 and article 2(1)(17) MiFIR
[15] Draft regulatory technical standards on transparency requirements in respect of bonds, structured finance products, emission allowances and derivatives, 28 September 2015, ESMA, p. 77 : a sovereign bond is deemed not to have a liquid market if the issuance size is smaller than 1,000,000,000 € (RTS 2)
[16] See above, p. 61
[17] Article 20(2), MiFID 2
[18] T. Aron, “Organised trading facilities: how they differ from MTFs”, Financier Worldwide Magazine, July 2015
[19] Last month, the EU Commission proposed a 1-year delay regarding the date of application of MiFID 2, i.e. from 3 January 2017 to 3 January 2018, due to the technical implementation challenges faced by the regulators and market participants. The EU Parliament later agreed that proposal and added an amendment to extend by a year the transposition deadline, i.e. from 3 July 2016 to 3 July 2017.
[20] A. Reygrobellet, “Les OTF : une réponse pertinente aux failles de MIF I ? », Bulletin Joly Bourse, November 2015, n° 11, p. 526