Making Sense of MiFID

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.

Stephen McGoldrickOrganized 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.

Appropriate transparency is fundamental to any market but the operative word is appropriate. If transparency is an end in itself, it could become detrimental to market participants. For a market with participants who operate at very different sizes, you cannot have a one-size-fits-all approach. Some participants may wish to rapidly trade 5% or 10% of the listed capital of a company while others might simply want to trade a few hundred pounds worth of shares. It is inexplicable to think that a singular approach will work for such vastly different-sized activities.

Algo Trading and Market Stability
The general regulation of algorithms in MiFID II looks sensible: that automated software for generating orders should be properly tested and documented by each organization. We see no harm in the regulators knowing what those algorithms are doing. Whether or not they want every change communicated to them is another matter, as many firms regularly make minor changes to algorithms. Inserting the regulator into the release cycle of software is less palatable, but having a robust control mechanism and obligations to test are sensible.

Where the regulation does not work is the requirement that every algorithm must continue to push liquidity regardless of prevailing market conditions. As drafted currently, this concept displays a real misunderstanding of how electronic execution works. Instead of identifying a particular subset of High Frequency Trading (HFT) and creating an obligation to assist with liquidity, a far better way is to create a marketplace that incentivizes the provision of liquidity. Forcing traders to take on risks they are not comfortable with is contrary to the central policy of de-risking the market. If a trader leaves the market because they cannot manage their risk, requiring them to take on risk in the first place is perilous.

What needs to be discussed with the regulators? Code review is impractical, but traders should be willing to explain an algorithm’s concept. If there had to be a record of what an algorithm was supposed to do, but in reality it does something else, then a difficult conversation with the regulator would ensue. A far more sensible approach is to categorize different types of activity, ensuring that liquidity providers are regulated and monitored, but also to have an ongoing incentive, perhaps being registered as market makers. The old model was that when a firm registered as a market maker, they received certain privileges as a reward for taking on those obligations.

The fundamental break in the proposal is that it fails to differentiate between algorithms that are execution tools for large orders and algorithms that take a wholesale interest in the market and slice it to minimize market impact. By not differentiating this from an algorithm that seeks to make markets by making two-way prices and exists purely as a liquidity provider, MiFID tries to fit two massively different things into the same rule book.

In many respects, this rule simply defines the best practice that most stockbrokers already apply to their algorithms. The trouble arises if this rule is intended to prevent a ‘flash crash.’ HFT did not create the ‘flash crash’, it was the oversell of some S&P mini-Futures by a traditional wholesale investor. It did involve a poor execution algorithm, which should have been tested better, but requiring all algorithms to make markets does not address this and will not prevent another ‘flash crash.’

Transparency and G20 Derivatives Commitments
We should clarify that the regulations about trading derivatives on OTFs are not about giving the regulators the ability to foresee market risk. They are about understanding where positions rest and seeing executions coming out of or being executed on an OTF or MTF. This type of post-trade transparency gives no additional ability to regulators to foresee risks evolving in the market. The risk in derivatives comes from where open positions rest – and the trade repositories (databases of open positions) and Central Counterparties (CCPs) provide this information. In concert with trade repositories, CCPs give regulators the ability to foresee concentrations of risk or when a market participant is taking on disproportionate risk in a particular area. Where the trade is executed has nothing to do with that.

The UK Financial Services Authority (FSA) has suggested that an OTF with a continuing ban on proprietary trading should fulfill the law, but in a market where 95% of the trades are done on a propriety basis, this proposal is fundamentally flawed. It should be very clear that for the OTF to fulfill the G20 commitments a ban on proprietary capital traded by an operator is not required and it must be revisited.

European Consolidated Tape
The mantra that transparency is a good thing seems to have been adopted somewhat simplistically. Reducing the post-trade delays permitted when banks execute positions on behalf of their clients will increase the spreads for the trade. Lower returns for investors are the result of premature flagging to the market, which pushes the price ahead of or away from the wholesale trader. We have lost sight of the fact that these delays have a role to play, and we should focus on establishing an appropriate delay period rather than merely shortening it. Pre-trade transparency – whereby orders must be transparent prior to execution – also uses a system of waivers that has been effective so far. Investor choice and trading efficiency have been created under the current structure, but there is a growing sense of transparency as binary; if transparency is a good thing, then a waiver on transparency must be bad. The concern is that regulators may seek to reduce the extent of the waivers as an end in itself, instead of deciphering their relative impact on efficiency and transparency.

Regarding the consolidated tape, there is a proposal that standard data formats are created, maintained and applied to all post-trade data. For trade data to use a standardized format whether it is executed on a regulated market, MTF or OTC implies benefits of efficiency and consolidatibility. The problem is that the commission proposed that multiple suppliers be allowed to act as consolidators of data. A European market where multiple vendors supply multiple tapes is no better than where we started from.

It has been suggested that ESMA and the commission maintain powers to implement such mechanisms that are required to ensure that the data is comparable. But what the markets need is certainty and clarity. The proposal would have carried more weight if providers were required to synchronize their offerings. Alternatively, mandating that there be one central provider would have been pragmatic as it would allow for easier debate about data pricing. Currently, there is a real risk that once all the data sources are compiled it will be prohibitively expensive. In this area, traders are again dependent on the commission’s powers to define reasonable commercial terms. We need to be able to rely upon this because otherwise it will take years of continued lobbying in order to establish what is already known: that market data is too expensive in Europe for a consolidated tape to be viable.

The lack of an affordable consolidated tape in Europe detracts from confidence in the markets. It is important for investors to know they can get out of their positions, make principal prices and have a clear understanding of what is happening in markets across Europe. Nothing is going to build liquidity in Europe more than confidence in the market structure.

FPL EMEA Regulatory Update
There is a considerable amount of activity taking place in the European regulatory environment and its impact is a central concern for many FPL member firms. As an organisation, FPL works closely with regulators globally to encourage the use of nonproprietary, free and open industry standards in the development of regulation, so all sectors of the financial community can benefit from increased consistency and transparency. The standards FPL promotes are those that have already achieved mass adoption by the trading community, enabling firms to more easily meet new requirements by leveraging existing investments across additional business areas.

FPL is increasingly approached to comment on regulatory consultations and in Quarter 1 2012, decided to re-convened the EMEA Regulatory Subcommittee to ensure that all responses submitted strongly reflect membership interests. FPL is pleased to announce that Stephen McGoldrick, Deutsche Bank and Matthew Coupe, Redkite Financial Markets have been elected to co-chair this group. Through their leadership the group will benefit from their extensive knowledge and experience. FPL welcomes participation in this group from all FPL member firms with an interest in the region, if you would like to find out more please contact fpl@fixprotocol.org.

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