With the publication of MiFID II and MiFIR in the Official Journal of the European Union the clock has now started ticking and trading venues and market infrastructure need to familiarise themselves with the new requirements and prepare themselves for regulatory change. MiFID II and MiFIR introduce important changes particularly with the introduction of a new type of trading facility and the implementation of the G20commitment to mandate the trading of standardised derivatives on exchanges and electronic platforms.
Alongside regulated markets (RMs) and multilateral trading facilities (MTFs) MiFID II and MiFIR introduce an additional category of trading venue, the Organised Trading Facility (OTF). Unlike an RM or MTF the OTF will only relate to bonds, structured finance products, emission allowances or derivatives. Another distinguishing feature of an OTF when compared to an RM and MTF is that a firm operating on an OTF can exercise discretion when deciding to place or retract an order on the OTF they operate and subject to certain requirements when deciding not to match client orders. Like an RM and MTF the operator of an OTF will not be allowed to trade against its proprietary capital. However, there will be an exception specifically for OTF operators in relation to sovereign debt instruments for which there is no liquid market. An OTF will also not be allowed to be a systematic internaliser (SI) nor to connect with an SI in a way which enables orders in the OTF and orders or quotes in the SI to interact.
A number of the organisational requirements that currently apply to RMs and MTFs will be extended to OTFs. For example, all must have transparent rules and procedures for fair and orderly trading and objective criteria for the efficient execution of orders, as well as transparent rules for determining which instruments can be traded and transparent, non-discriminatory and objective membership criteria. Each type of trading venue will also be subject to identical surveillance requirements with monitoring for compliance with their rules and monitoring of orders, cancellations and transactions undertaken in order to identify breaches, disorderly trading and market abuse. In relation to monitoring compliance ESMA has provided its initial thinking on draft regulatory technical standards (RTS) in its discussion paper. ESMA is intending to draft an indicative and non-exhaustive list of signals of market abuse behaviours. Such list will be based mainly on the CESR guidance on the application of MAD I.
HFT and algorithmic trading
MiFID II extends a general push towards a system which would require firms to be authorised before engaging in algorithmic trading, high frequency trading (HFT) or algorithmic trading with market making obligations.
For the first time trading platforms (and investment firms) will be subject to an EU harmonised regulatory regime specifically relating to HFT and algorithmic trading, market making and direct electronic access. Both the ESMA discussion paper and consultation paper add further colour to the new requirements. In particular, in the discussion paper ESMA states that it intends to base its technical advice on the RTS on the existing ESMA guidelines on systems and controls in an automated environment (published in February 2012). In addition, ESMA proposes to establish RTS setting out the minimum requirements that all trading venues should meet in relation to their trading systems linked to algorithmic trading. However, importantly, ESMA also states that trading venues should in all cases assess their degree of compliance taking into account the nature, scale and complexity of their business. Accordingly, in some instances more stringent organisational requirements might be required.
Transparency and transaction reporting
The general point is that the new regime significantly expands the current transparency regime.
The transparency and transaction reporting obligations in MiFIR apply to each type of trading venue, albeit calibrated for different types of instrument and different types of trading. The transaction reporting requirements are also extended to financial instruments traded on an OTF or whose value depends on such an instrument. Transparency and transaction reporting are discussed at length in both the consultation paper and discussion paper (the transparency section in the discussion paper is some 150 odd pages) and there is not enough room in this briefing to cover every issue. However, perhaps one of the key points is that MiFIR imposes an entirely new transparency regime for a wide range of non-equity instruments. The majority of the implementing measures for this new regime will take the form of RTS and in the discussion paper ESMAsets out its initial thinking on how this regime should work and what its scope should be. ESMA’s believes that the first and most important assessment it needs to undertake is the determination of whether an instrument has a liquid market. The reasoning for this is that trading an instrument having a liquid market is subject to real time transparency whereas illiquid instruments are eligible to be granted a waiver for pre-trade transparency and for deferred publication of post trade.
To ensure that shares are traded on venues that are subject to the transparency requirements, MiFIR provides that investment firms will need to ensure that trades in shares admitted to trading on an RM or traded on an MTF only take place on an RM, MTF, SI or equivalent non-EU trading system. An investment firm may execute a trade elsewhere but only if the trade is non-systematic, ad hoc, irregular and infrequent, or if it is carried out between eligible and/or professional counterparties and does not contribute to the price discovery process.
The push onto trading venues also applies to standardised OTC derivatives. MiFIR provides for a procedure for ESMA to designate derivatives that are subject to the clearing obligation under EMIR and which are sufficiently liquid, to be traded exclusively on RMs, MTFs, OTFs or non-EU trading venues deemed equivalent by the European Commission. ESMA will publish and maintain a register specifying the derivatives that are subject to the trading obligation, where they are admitted to trading or can be traded and the dates from which the obligation takes effect.
ESMA acknowledges that the trading and clearing obligation are linked and that the relevant rules under MiFIR should be as consistent as possible with those under EMIR. Under EMIR ESMA has allocated over-the-counter (OTC) derivatives to classes which are further split into sub-classes. Under EMIR every time a class of derivatives (or relevant sub-set) is declared subject to the clearing obligation, ESMA has 6 months in which to bring forward RTS stating if they should also be subject to the trading obligation and if so, when. With the exception concerning the relationship of third countries to the trading obligation, ESMA has decided that the trading obligation process under MiFIR will not require RTS. Instead, ESMA proposes that it will mostly respond to decisions taken under the clearing obligation.
MiFID II extends the SI regime so that it applies not just to shares but also equity like instruments (depositary receipts, exchange traded funds, certificates and other similar financial instruments) and non-equity instruments (derivatives, bonds, structured finance products and emission allowances). MiFID II also introduces a new definition for an SI which is based on quantitative criteria for assessing when the activity of dealing on own account by executing client orders is sufficiently frequent, systemic and substantial. Both the discussion paper and the consultation paper cover the SI regime with the former dealing with the new definition and the meaning of ‘frequent’, ‘systemic’ and ‘substantial’.
SME Growth markets
One of the aims of MiFID II is to facilitate access to capital for SMEs and the development of specialists markets catering for the needs of SMEs. MiFID II seeks to establish a regime for the registration of MTFs offering facilities to SMEs as ‘SME growth markets’ (SME-GM) where they meet certain criteria. MiFID II requires that at least 50% of the issuers whose financial instruments are admitted to trading on an MTF registered as an SME-GM are small and medium sized enterprises at the time the MTF is registered as an SME-GM and in any calendar year thereafter. In the consultation paper ESMA provides draft technical advice for the delegated act which specifies further how the requirement of at least 50% of issuers on an SME-GM being SMEs is to be applied.
Access to CCPs and trading venues
MIFIR provides for trading venues to have access to central counterparties (CCPs), and vice versa, subject to certain conditions. This extends to other financial instruments the rights of access created by EMIR in relation to OTC derivatives. The discussion paper covers a number of points that ESMA must consider when developing its RTS on this issue. In particular on the grounds for denying access ESMA notes that whilst the legal text of the empowerments under MiFID are very similar in practice they may impact CCPs and trading venues differently. To this end, ESMA provides two separate analysis. Also, MiFIR gives a trading venue or CCP a right of access to benchmarks so that they can trade or clear relevant financial instruments. ESMA acknowledges that MiFIR covers a vast array of benchmarks and consideration will need to be given to take all of these into account.
MiFID II provides that trading venues should ensure that their rules on co-location services are transparent, fair and non-discriminatory. One of the points that ESMA picks up on in its discussion paper is that when deciding whether co-location services are transparent and fair, the pricing of such services must also be considered, primarily whether the pricing models used by the providers are applied in a transparent, fair and non-discriminatory manner to all users of the service.
Indirect clearing arrangements
The very last section of the discussion paper covers indirect clearing arrangements. The mandate given to ESMA regarding the development of RTS to specify the types of indirect clearing arrangements in the scope of MiFIR is very similar, but not identical, to the mandate granted under EMIR. At this stage ESMA is asking stakeholders whether it should adopt a different approach to that used for EMIR.