Regulated Markets, Multilateral Trading Facilities (MTF) and Systematic Internalisers (SIs) were among the most scrutinised technical jargon of the first MIFID, implemented in the UK in November 2007. In keeping with this spirit, MiFID II introduces novel technical concepts for regulators and the regulated to grapple with.
In this briefing, we highlight some of the important changes for financial services firms which will affect how and where they execute transactions after the implementation of MiFID II. All comments are based on the publications available at the time of writing.
MiFID II introduces new Trading Obligations for two classes of financial instruments, shares and derivatives.
From 3rd January 2018 it will be mandatory for investment firms to execute on a regulated market, MTF, SI or equivalent third country venue all trades in shares that are admitted to trading on a regulated market. This includes trades where a firm is dealing on own account or executing client orders. The Trading Obligation (TO) applies unless the transactions are non-systemic, ad hoc, irregular and infrequent (i.e. there is a legitimate reason for deviating from the obligation) or the transactions are expressly excluded as not contributing to the price discovery process. ESMA has outlined the latter transactions in RTS 1 and they include, among others, give-ups or give-ins and transactions executed by management companies or AIFMs where there is a transfer of beneficial ownership but no investment firm is party to the transaction.
ESMA is not required to include definitions of what is non-systemic, ad hoc, irregular or infrequent. However, it did indicate that a “reasonable interpretation of what is ‘infrequent’ to be an activity which does not meet the frequency and systematic thresholds set for systematic internalisers.”
It has been expressly stated in the recitals to MiFIR that any exclusion from the TO should not be used to circumvent the regulations and the message from ESMA is that the exclusion is unlikely to apply in a wide variety of circumstances. This is in keeping with ESMA’s wider objective of enhancing transparency in the financial markets by forcing more trading onto venues, thereby limiting OTC business for equities.
The TO for derivatives highlights the area where there is significant interdependence between the European Markets Infrastructure Regulation (EMIR) and MiFIR and requires the mandatory trading of certain derivatives on trading venues. The obligation is applicable to Financial Counterparties or Non-Financial Counterparties (as defined under EMIR) requiring them to trade derivatives which are subject to the EMIR clearing obligation, on a regulated market, MTF, Organised Trading Facility (OTF) or equivalent third country venue. As there is an express link to the clearing obligation, a derivative will not be subject to the trading obligation if it is not also subject to clearing.
Once a derivative has been mandated as subject to clearing under EMIR, ESMA must then determine if the contract(s) should be subject to the trading obligation and it has six months in which to make this determination. There are two main factors that will determine this: firstly the ‘venue test’; where the class of derivatives must be admitted to trading or traded on at least one trading venue; and secondly the ‘liquidity test’; whether there is sufficient third party buying and selling interest in the class of derivatives to ensure it is considered liquid.
Given those instruments that are currently, or planned to be subject to the clearing obligation under EMIR – under the phased approach and dependent upon counterparty categories and trading volumes – ESMA proposes to follow a similar approach when implementing the TO. This will mean that some instruments will be subject to the trading obligation from 3rd January 2018, however others will follow at a later date.
Firms should therefore be aware of the possible limitations imposed on their executions from 3rd January 2018 and examine where and how they will need to execute transactions in both shares and derivatives. They will need to consider how these changes will impact on market liquidity and the ability to get the executions they desire. Furthermore firms should be mindful that the venues will be publishing data on their trading and that this data should be used to support scrutiny of their best execution obligations and their transaction cost analysis.
As the TO requires certain trading to take place on venues, MiFIR has also taken steps to ensure that there is a consistent level of regulation and expectation applicable to the various types of venues, whilst also introducing a new type of venue and significantly enhancing the SI regime. These enhancements go hand in hand with the overarching transparency objective.
The operational requirements for Regulated Markets and MTFs have been aligned under MiFID II as they are broadly viewed as similar execution venues. OTFs have also been brought into scope in a number of instances to ensure a degree of harmonisation.
All venues are required to have rules and procedures for fair and orderly trading and criteria for efficient order execution, as well as rules and criteria regarding the financial instruments that can be traded on their systems. Access to their facilities should be non-discriminatory and transparent (‘open access’), and the venues must at all times have at least three materially active members. Furthermore, there are enhancements to governance requirements and express monitoring requirements in respect of conflicts of interest, infringements of rules and market abuse.
MiFID II has also reacted to technological advances in financial markets, particularly in respect of algorithmic and high-frequency trading, and trading venues are now required to have effective systems, procedures and arrangements to ensure their systems are resilient, with sufficient capacity (especially at peak times) and are able to resume activity following disruptive incidents.
MiFID II introduces the new concept of an OTF. An OTF is a “multilateral system … in which multiple third-party buying and selling interests in bonds, structured finance products, emissions allowances or derivatives are able to interact in the system in a way that results in a contract”. Operating an OTF is classed as an investment service and therefore operators are required to be authorised. Facilities where there is no genuine trade execution or arranging taking place, for example bulletin boards, are out of scope; however an OTF can arrange transactions in non-equities by facilitating negotiation between clients to bring together two or more comparable trading interests.
OTFs are designed to complement existing trading venues and have been created with the aim of increasing price discovery and investor protection whilst reducing the overall impact that opaque markets have. As such, “conduct of business rules, best execution and client order handling obligations should apply to the transactions concluded on an OTF operated by an investment firm” .
One of the key differences between OTFs and the more established execution venues of MTFs and Regulated Markets is that for OTFs execution, although non-discriminatory, is discretionary; MTFs and regulated markets are not afforded that choice.
As an OTF is a genuine trading platform, it should be neutral and therefore subject to the requirements relating to non-discriminatory execution whilst also prohibiting the execution of client orders against proprietary capital for the operator or any entity that is part of the same group. There is a notable exception to this for sovereign debt instruments for which there is not a liquid market. Matched principal trading is permitted with the express permission of the client for instruments that are not subject to clearing under the EMIR.
In respect of discretion, OTFs have two levels where this can be exercised: first when deciding whether to place or retract an order; second when deciding whether to not to match a specific order with other orders available in the system at any given point in time.
OTFs have been introduced in conjunction with the TO and enhancements in the transparency regime to capture organised trading in non-equities that currently takes place outside of Regulated Markets or other trading venues. Firms transacting in these instruments will need to be mindful of where they can trade from 3rd January 2018.
SIs are already subject to supervision under MiFID I. There have been a number of subtle changes to the definition of an SI, which now reads as “an investment firm which, on an organised, frequent systematic and substantial basis, deals on own account when executing client orders outside a regulated market, an MTF or an OTF without operating a multilateral system.” This has the effect of expanding the instruments caught by MIFID II to equity-like instruments such as depositary receipts, certificates and exchange traded funds and non-equity instruments such as bonds, derivatives, emissions allowances and structured finance products.
The guidance on what is considered to be ‘frequent systematic and substantial’ has also been clarified, with frequency measured (depending on whether the instrument is considered liquid or not) either by the number of transactions or the regularity of trading and substantial measured by the size of transactions compared to total firm trading or EU trading. These thresholds are specific to each instrument type, be it equity, equity-like or non-equity. The introduction of quantitative thresholds has meant that a number of firms that were previously out of scope, or in scope but with limited obligations, may now find themselves in scope of the Systematic Internaliser regime. MIFID II has provided clarity on what types of entities may be caught by the SI regime; for example, broker crossing networks and single-dealer platform where trading takes place against a single investment firm.
In respect of dealing on own account, matched principal trading (‘back to back trading’) is considered to be caught within the definition (“trading against proprietary capital resulting in the conclusion of transactions in one or more financial instruments” ) as outlined in the Recitals to MiFID at paragraph 24 . Thus, brokerage firms operating in this way may find themselves in scope of the SI regime or, where their activities bring together third-party buying and selling interests in functionally the same way as a trading venue, the OTF regime.
ESMA recently published an update to its Q&A Paper on MiFID II and MiFIR Transparency topics where it provided an update on the SI regime. In summary, the Paper confirmed a ‘slight’ delay to the implementation of the regime to 1st September 2018. Assessments of the thresholds which could bring investment firms into scope depending on the instruments they trade were originally scheduled to occur quarterly starting on first working day of January. However, since the first calculations are only expected to be possible after 6 months of data is available, ESMA will publish information concerning the total number and volume of trading by 1st August 2018 (which will cover the period from 3rd January to 3rd June 2018). This means that investment firms will need to be conducting their assessments of their trading against these statistics in August next year and be ready to comply from 1st September 2018.
This delay also applies to illiquid instruments, despite it being possible for those firms that may be systematic internalisers to carry out themselves part of the test based on data available to them. ESMA is of the view that a complete assessment requires comparison with the trading activity across the EU and therefore in order to provide a consistent assessment and ensure the treatment of all investment firms is aligned this should be performed after 1st August.
For subsequent assessments ESMA “intends to publish the necessary information within a month after the end of each assessment period” which will coincide with the first calendar day of February, May, August and November annually. Firms will then have two weeks to comply with the obligations imposed on SI firms– i.e. by the fifteenth calendar day of the same months.
ESMA has however stated that this delay does not preclude investment firms from opting in to the regime, “as a means of complying, for example, with the trading obligation for shares” .
Firms that, as a result of the expansion of the instruments in scope, or following clarity provided concerning the thresholds, may fall within the scope of these rules should be mindful of the above dates and ensure they are prepared to meet the obligations imposed upon them, including pre and post-trade transparency requirements and data publication requirements.
For firms that require more information on the impact of MiFID II, Cordium has prepared a detail impact assessment to help clients identify all their regulatory obligations under MiFID II. For further information contact Sarah Donnelly (email@example.com) or Charlotte Malin (firstname.lastname@example.org).
 The Regulatory Technical Standards on Transparency requirements for trading venues and investment firms in respect of shares, depositary receipts, exchange-traded funds, certificates and other similar financial instruments and on transaction execution obligations in respect of certain shares on a trading venue of by a systematic internaliser
 Discussion Paper MiFID II/MIFIR, ESMA/2014/548, Paragraph 8, Page 101
 MiFID Recitals Paragraph 9
 MiFID Article 4(1)(20)
 MiFID Article 4(1)(6)
 Dealing on own account when executing client orders should include firms executing orders from different clients by matching them on a matched principal basis (back-to-back trading), which should be regarded as acting as principal and should be subject to the provisions of this Directive covering both the execution of orders on behalf of clients and dealing on own account.