As lawmakers look to reform aspects of wholesale markets regulation, the UK may be poised to drift closer to the US.

In his Mansion House speech on July 1, 2021, Rishi Sunak, the then-Chancellor of the Exchequer, announced his vision to improve the competitiveness of the United Kingdom's financial services sector while maintaining high regulatory standards. This launched HM Treasury's Wholesale Markets Review, which sought input from stakeholders across the financial services sector.

2021

PFOF practice came under heavy scrutiny following the GameStop scandal

 

HM Treasury published its Consultation Response in March 2022, and its proposals will be implemented through a combination of legislation and regulatory developments. The UK's Financial Services and Markets Bill 2022-23, which proposes a broad range of changes to the UK's financial services sector, incorporates a number of the recommendations proposed in the Wholesale Markets Review. In parallel, the UK's Financial Conduct Authority (FCA) has been tasked with implementing some of the new proposals through new and existing regulatory powers.

This article focuses on some of the upcoming changes that are driven by the Wholesale Markets Review, and examines how these changes may impact infrastructure providers and market participants. We assess the developments through the prism of three core themes: addressing economic inefficiencies, improving securities regulation, and moving from legislation to regulation.

We will also look at similar reform initiatives in the European Union and the United States, and examine whether the UK's approach suggests a drift from its continental neighbors toward a closer alignment with the US.

Addressing economic inefficiencies

The recast Markets in Financial Instruments Directive (MiFID II) introduced a number of structural reforms to the securities regulatory framework in the EU (including, at the time, the UK). These reforms were driven, in part, by the 2008 financial crisis, as there was an increased emphasis on market transparency and the need to strengthen investor protection. Several of the proposals introduced by the Wholesale Markets Review seek to address developments in the UK economy since MiFID II was implemented.

Trading venues and systematic internalizers

When MiFID II took effect in 2018, it imposed various operational conditions on multilateral trading facilities (MTF) and organized trading facilities (OTF). One of the aims of the Wholesale Markets Review was to assess whether these changes were beneficial, or whether they had the unintended effect of discouraging new market entrants and stifling innovation.

One of the restrictions imposed by MiFID II was to prohibit MTF operators from engaging in matched principal trading to avoid conflicts of interest arising where an MTF operator wanted to execute a trade on its own trading venue. The UK government agreed with the majority of respondents that this prohibition was costly and unnecessary, as MTF operators are already obliged to identify and manage conflicts. Separately, the consultation sought views on whether OTFs—which are fundamentally non-equity venues—should be permitted to execute derivative package trades that include an equity product. This change would allow a derivative package trade to be executed in its entirety on an OTF, rather than splitting execution across two venues. The UK government agreed with respondents that this change would cut unnecessary costs and reduce execution risk.

The FCA has been tasked with implementing these changes as part of the Future Regulatory Framework, which is a parallel initiative to reform the UK's financial services regulatory framework post-Brexit.

The Wholesale Markets Review also addressed regulatory requirements that may have had a negative economic impact on systematic internalizers (SIs). SIs are investment firms that deal on their own account when executing client orders outside of a trading venue on an organized, frequent, systematic and substantial basis. The MiFID II definition of "systematic internalizer" introduced complex quantitative calculations that apply on an asset class basis in which the calculations have to be updated periodically. The Wholesale Markets Review notes that many firms choose to opt out of the regime rather than engage with the calculation requirements. The UK government supported the move from a quantitative to a qualitative definition, which would allow more firms to opt into the regime without carrying out costly and burdensome calculations. This is reflected in the bill, which uses a qualitative definition and provides the FCA with the power to specify how it should be interpreted.

Share trading obligation

A major outcome of the Wholesale Markets Review is the proposed removal of the share trading obligation (STO) that was implemented as part of MiFID II. The UK's STO applies to shares that are admitted to trading on a trading venue, and requires investment firms to trade them on a UK-regulated market, a UK MTF, through a UK SI, or on an overseas venue that the HM Treasury has assessed as equivalent. Although the purpose of this requirement was to increase transparency, respondents noted that the removal of the STO would allow firms to trade in the most liquid market and achieve the best execution for their clients.

The UK government agreed with this view, and accordingly, the bill proposes removing the STO. This would be a significant change for UK investment firms, as it would allow firms to trade in-scope shares on any UK or non-UK trading venue (subject to separate MiFID-derived requirements to achieve the best execution).

Algorithmic trading

Another economic impact identified by the Wholesale Markets Review was in the algorithmic trading space. MiFID II requires firms that engage in algorithmic trading to enter into market-making agreements with trading venues as a condition to pursuing market-making strategies. Respondents supported the removal of this requirement because it was an additional cost and did not meaningfully contribute to market quality. The FCA is considering the best way to implement this change as part of the Future Regulatory Framework.

Improving securities regulation

In addition to reducing what it identified as unnecessary costs and burdens on market participants, the Wholesale Markets Review sought to improve certain aspects of the UK securities regulatory framework.

Market outages

One of the consultation's key focus areas is how to improve market resilience during a market outage. In early 2022, the FCA consulted on how it can use its current tools to clarify what should happen when there is a market outage, and it plans to put forward proposals later in the year. A primary focus of this effort will be on delineating the responsibilities between market operators and participants, and a possible outcome may be the development of a playbook for trading venues and participants to follow during an outage.

Equity markets

A number of the proposed changes in the Wholesale Markets Review are aimed at improving the operation of the equity markets. For example, HM Treasury recommended the removal of the double volume cap (DVC), which was introduced by MiFID II and limits the amount of trading that can happen without pre-trade transparency. Respondents argued that the DVC was arbitrary and unhelpful, noting that there were no negative impacts on price formation since the FCA suspended the DVC for UK and EU securities in 2021. The UK government supported this view, and the removal is reflected in the bill.

Another change aimed at improving the functioning of the equity markets is a proposed adjustment to the tick size regime. The tick size regime sets minimum increments by which prices for equity and equity-like instruments can change, and limits the ability of trading venues and SIs to cross at the midpoint. The regime was introduced by MiFID II to prevent tick sizes from being used as a competition tool between venues because it was detrimental to the price formation process.

While the Wholesale Markets Review is supportive of the tick size regime, it proposes that trading venues should be allowed to follow the tick size applicable to a share's primary market (even if overseas). This is in contrast to the current position where tick sizes are calculated based on trading volumes on the most relevant market (in terms of the share's liquidity) in the UK and EU, which can lead to unnecessarily large tick sizes and increased costs. The FCA sought views on its proposals to implement this change as part of its consultation on Improving Equity Secondary Markets and is considering the responses. The Wholesale Markets Review also proposed allowing trading venues to establish tick sizes for new shares rather than the FCA making an estimate of liquidity. The FCA plans to carry out further work on this proposal at a later date under the Future Regulatory Framework.

Aligning trading and clearing obligations

MiFID II introduced a derivatives trading obligation (DTO) that requires in-scope firms to trade certain classes of derivatives on a UK trading venue or an overseas venue that the HM Treasury has assessed as equivalent. This operates alongside the mandatory clearing obligation under EMIR (European Market Infrastructure Regulation), but, crucially, without legislative alignment: The DTO and the clearing obligation apply to different categories of firms. Following the recommendation in the report, the bill realigns the counterparties in scope of the DTO with those that are in scope of the clearing obligation under EMIR1. To future-proof the position, the application of the DTO will expressly link to the application of the clearing obligation. The EU is considering a similar alignment of its DTO with the scope of the EU clearing obligation as part of its proposed reforms.

Moving from legislation to regulation

The Wholesale Markets Review's third core theme is a move from prescriptive legislative requirements in favor of regulatory powers to presumably allow for increased flexibility, particularly in cases where the regulator may need to act quickly to address market movement.

Derivatives trading

One of the proposals would give the FCA permanent power to modify or suspend the DTO to prevent or mitigate disruption to the markets, which is reflected in the bill. The UK government is also proposing to delegate the transparency regime for fixed income and derivative instruments to the FCA to reduce complexity. To that end, the bill removes the current legislative regime and provides new rule-making powers to the FCA to develop a new regime.

Transparency waivers

MiFID II introduced pre-trade transparency requirements and a system of waivers that may be used in specific circumstances to waive pre-trade transparency requirements. While pre-trade transparency aids price formation and helps firms achieve best execution, the system of waivers recognizes that transparency in every circumstance can impair liquidity. Trading venue operators may apply to the FCA to use some or all of the available pre-trade transparency waivers on their venue.

Rather than continuing with a system where the conditions for using pre-trade transparency waivers are enumerated in legislation, the Wholesale Markets Review proposed a new rule-making power for the FCA in which the FCA determines when pre-trade transparency waivers are permissible and how they are to be applied. The revocation of the existing system is reflected in the bill, as are the FCA's new powers.

Market data

As part of its changes to the EU market data framework, MiFID II proposed a new category of regulated firm: a consolidated tape provider (CTP). A CTP is authorized to collect trade transparency data from trading venues and data reporting service providers, and then consolidate them into a continuous electronic live data stream. The purpose of a consolidated tape is to bring price and volume data about a particular financial instrument into a single place to provide a full view of the market.

There was little appetite in the private sector to take up this regulated function because, in part, the prescriptive requirements for the operation of a consolidated tape made the proposition commercially unworkable. A CTP would need to ensure that the requisite percentage of the market was captured in the consolidated tape, which would present a particular challenge for the non-equities market.

In an effort to move away from the problematic requirements set forth in the legislation, the Wholesale Markets Review proposes that the FCA should be responsible for establishing requirements for an authorized CTP. The FCA has been consulting on certain changes to support the development of a UK-consolidated tape.

EU developments

The EU financial markets experienced a substantial regulatory overhaul when MiFID II was implemented, affecting both the EU27 countries and the UK. Following Brexit, however, each additional amendment to the regulatory regime poses the risk of the UK and EU regimes moving in different directions. This is particularly true for the European Commission's new legislative proposals to reform MiFID II and the Markets in Financial Instruments Regulation (MiFIR).

Reviewing MiFIR and MiFID II

The European Commission's review of MiFID II and MiFIR helped to identify ongoing issues and potential amendments to improve the competitiveness and security of the financial markets. For example, it found that (i) information barriers were preventing share price transparency for investors in EU capital markets; (ii) market fragmentation was preventing smaller asset managers and banks from accessing market data across different venues as easily as investment banks and other highly technically equipped market participants; and (iii) a lack of accurate, timely information on prices and available volumes of traded securities was causing continued liquidity and trade execution risk in the market.

To address these issues, the Commission proposed amendments to MiFID II2 and MiFIR3, with the aim of achieving a Capital Markets Union, and, as a result, provide investors with more opportunities to participate in the European financial markets, thus increasing market liquidity in the long term. The changes also seek to promote an efficient internal market for trade by improving transparency and the availability of market data, creating a level playing field among execution venues and ensuring that EU market infrastructures remain competitive internationally.

Changes addressing economic inefficiencies

As in the UK, several of the proposed EU amendments seek to address economic developments since MiFID II took effect. For example, the requirement for all multilateral systems to operate as a regulated market, MTF, or OTF and the provisions on the distinction between an MTF and an OTF are moved from the MiFID II to MiFIR, making them directly applicable under EU law (rather than through transposition by the member states). This move is intended to increase harmonization among EU member states and improve financial stability in the EU market.

Another change is the proposed removal of the "open access" obligation for exchange-traded derivatives. The requirement for clearing infrastructures in the EU to clear derivatives trades that are not executed on their vertically integrated trading platform would be deleted to strengthen EU clearing markets.

The Commission is also proposing a ban on payment for order flow (PFOF), which is controversial in some member states. PFOF involves a broker receiving remuneration from a market maker in exchange for passing on client orders to them. The ban on PFOF was proposed to prevent the practice of certain high-frequency traders organized as SIs paying high commissions to brokers so that they would channel their retail orders to them for execution—a practice that came under heavy scrutiny in 2021 following the GameStop scandal. Although the proposed ban aims to protect investors, it has been argued that it would increase trading costs for retail market participants and that a detailed review of the execution of private client orders would be more sensible than a complete ban. It remains to be seen whether the ban will be implemented in the EU; PFOF is banned in the UK4, and the US is also considering whether to ban or restrict the practice5.

Other proposed changes to the EU rules include (i) removing the best execution reporting obligation for execution venues, which was found not to give investors an efficient comparison or to be necessary if a consolidated tape was implemented; and (ii) deleting the requirement to register as a securities company for those dealing on its own account using direct electronic access (DEA) to help level the playing field with third-country individuals who access EU venues through DEA without registering.

Changes that improve securities regulation

Similar to the UK, the EU is also proposing changes aimed at improving aspects of the EU securities regulatory framework.

While the UK plans to remove its DVC, the EU plans to replace the current DVC mechanism (under which the volume of anonymous trading in an equity instrument must not exceed 4 percent of the total trading in that instrument or 8 percent of total trading within the EU) with a single volume cap.

Whereas the UK is planning to remove its STO, the EU is proposing to define the perimeter of the EU STO to include shares admitted to trading on an EEA (European Economic Area) regulated market and with an EEA ISIN (international securities identification number), and establish an EU "official list" of shares subject to mandatory trading. An exception from the STO is made for shares traded on a third-country trading venue in the national currency, while other exceptions (for example, ad hoc, irregular and infrequent transactions) are deleted.

Like the UK, the EU is also planning to improve its consolidated tape rules to enable the emergence of one CTP for each asset class. All trading venues and SIs will be required to make market data available to the respective CTP and, thus, the quality of that data will be improved by harmonizing data reports and introducing standards for quality of service applicable to all CTPs. These key changes should lead to a comprehensive overview of prices and volumes of traded equity, and quasi-equity financial instruments and, it is hoped, result in stronger, more transparent and more competitive EU financial markets.

Finally, with sustainability continuing to be an increasingly hot topic, the EU has introduced a number of changes to MiFID II through its new Delegated Regulation (EU) 2021/1253, which took effect on August 2, 2022. Under the regulation, investment advisors must obtain information about the sustainability preferences of their clients and take them into account when selecting financial products. The choice of a particular financial instrument is considered part of a client's "sustainability preferences" if it falls within the EU taxonomy, is "sustainable" under the Sustainable Finance Disclosure Regulation, or if the instrument considers the most significant adverse effects on sustainability. Investment advisors now also have a far-reaching duty to disclose the sustainability objectives of a product and corresponding risks.

US developments

Similar reforms may be on the horizon in the US where US Securities and Exchange Commission (SEC) chair Gary Gensler used a June 2022 speech6 to outline plans to reform the US equity market. The changes, which were at the "proposed rule stage" on the SEC's regulatory agenda for spring 2022, aim to modernize requirements around equity market competition and structure, including those concerning order routing and PFOF, conflicts of interest, best execution, market concentration, pricing increments, transaction fees, core market data and disclosure of order execution quality statistics.

The US proposals have some similar themes as the proposed UK changes. Like several of the UK changes, the potential SEC reforms are intended to address recent economic developments, including the heightened interest in certain "meme stocks" in January 2021 that led to increased market volatility. Following those events, the SEC identified a need for greater transparency. The SEC proposals include rule updates to provide investors with more useful disclosure about order execution quality.

Gensler, a driver for the changes, also noted the need to "look for opportunities to freshen up our [SEC] rules to ensure America remains the gold standard of the world's capital markets," suggesting a desire to focus on maintaining strong US regulation in all areas. An example of this is the SEC's recommended changes to its tick size regime to level the playing field by harmonizing tick sizes across different market centers and reducing the minimum tick size to better align with off-exchange activity. The SEC is also considering its own best execution rules for equities and other securities; these rules are currently imposed by other US self-regulatory bodies on broker-dealers, but not by the SEC, which relies on common law obligations to establish the broker-dealer's duty of best execution.

Conclusion

Although the EU and the US are both considering reforms that follow similar themes to those proposed in the UK, several of the UK's proposals go further than the EU's by removing or reducing restrictions intended to protect market participants in the interest of improving efficiency in securities markets. The UK's removal of the STO, for example, arguably reduces transparency in the interest of best execution while the EU plans to retain the obligation, albeit in an amended form. The UK is removing the double volume cap, again, potentially reducing transparency for efficiency, whereas the EU is swapping it for a single volume cap. Moreover, the deletion in the UK of the MiFID II requirement for firms engaging in algorithmic trading to enter into market-making agreements with trading venues also suggests a move away from the EU approach. With the US still to confirm the details of its plans for reform in this area, it is possible that we are starting to see the UK's post-Brexit rules diverging from those of the EU and drifting closer to the approach taken across the pond.