MiFID II Academy: proprietary trading and trading venues. Floortje Nagelkerke 7 December 2017

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1 MiFID II Academy: proprietary trading and trading venues Floortje Nagelkerke 7 December 2017

2 The countdown to MiFID II / MiFIR implementation as of 8:30am this morning 27 DAYS 15 Hours 30 Minutes But if you take away weekends and public holidays it is really 18 working days! 2

3 Dutch transposition MiFID II implementation Article 93 MiFID II: Member States shall adopt and publish, by 3 July 2016, the laws, regulations and administrative provisions necessary to implement this Directive Status of implementing legislation in the Netherlands: Act implementing MiFID II: adopted by the Dutch Parliament on 26 September 2017 and preliminary report published by Dutch Senate on 31 October Decree implementing MiFID II: no updates since the public consultation of the draft decree in March - April Draft of Regulation competence employees investment firms published for consultation on 17 November How to keep informed: AFM MiFID review page

4 Introduction

5 Why is the distinction of trading venue or SI important? Best execution Trading obligations Transparency? Applicability other EU rules Z Asset manager Introducing broker Agency broker Executing broker 5

6 Trading obligations: shares and derivatives Shares What? Shares admitted to trading on a regulated market or traded on an MTF Where? Regulated Market, MTF, Systematic Internaliser Equivalent third country trading venue Who? Investment Firms Only investment firms can be direct members of trading venues Trading obligation does not apply to trades that are: Non-systematic, ad hoc, irregular and infrequent; Carried out between eligible and / or professional counterparties and do not contribute to price discovery; In shares or equity instruments not admitted to trading on a regulated market or traded on an MTF; or By non-investment Firms (only) These parties / instruments can trade OTC Derivatives What? Derivatives that are traded on a trading venue that are sufficiently liquid and declared subject to the trading obligation Where? Regulated Market, MTF, OTF Equivalent third country trading venue (see decision Commission on US TVs) Who? Transactions between: An FC and another FC An FC and an NFC+ An NFC+ and another NFC+ (and third country entities that would be subject to clearing obligation in certain cases) Trading obligation does not apply to: Non-equity instruments that have not been declared subject to the trading obligation Any trade with an NFC- (including if it trades with an FC or NFC+) Intragroup transactions These parties / instruments can trade OTC or on an SI 6

7 Trading models

8 Trading venues Regulated Markets (RMs) Non-discretionary execution Managed by market operator Operating is not an investment activity or service Multilateral Trading Facilities (MTFs) Non-discretionary execution Market operator or IF managed Operating is an investment service Few conduct of business rules apply Multilateral systems Multiple third party trading interests interact in the system in a way that results in the formation of contracts Organised Trading Facilities (OTFs) Discretionary execution Market operator or IF managed Operating is an investment service Investor protection, conduct of business and best execution apply 8

9 MTF MTF: "a multilateral system, operated by an investment firm or a market operator, which brings together multiple third-party buying and selling interests in financial instruments in the system and in accordance with non-discretionary rules in a way that results in a contract" Multilateral system Not bilateral: can t enter into every (any) trade on own account, even as riskless principal Multiple third party interests can interact AFM Robeco case law ESMA Q&A on market structures: OTF Non-discrimination Brings together multiple interests To be understood in broad sense Includes orders, quotes and indications of interest User ratification does not undermine this In the system A set of rules - no need for a technical system for matching orders Includes systems where users can execute against multiple quotes requested Bring interests together under the rules, protocols or operating procedures Broker agreements? In accordance with non-discretionary rules Rules leave the operator with no discretion as to how interests may interact Limited development on this; other than OTF discretion Users can have discretion 9

10 MTFs and trading protocols (discretion) MTF: "a multilateral system, operated by an investment firm or a market operator, which brings together multiple third-party buying and selling interests in financial instruments in the system and in accordance with non-discretionary rules in a way that results in a contract" Scenario #1: A trading platform has multiple participants. These submit orders to an order book. Orders are matched (usually on a price-time basis) automatically by the platform. Neither the participant nor the platform operator can do anything after submission of the order that would affect whether or how orders are matched. Such a platform would quite clearly be an MTF. This is because: 1) by having multiple participants able to interact in the order book it is "multilateral"; 2) orders are "brought together" by being able to interact directly in the order book; 3) orders fall within "buying and selling interests"; 4) the operator has no ability to force / prevent trades to occur so the rules are "non-discretionary"; and 5) because the participant cannot make a choice after submitting an order whether or not to trade, the system "results in a contract". 10

11 MTFs and trading protocols (RFQ and RFS) MTF: "a multilateral system, operated by an investment firm or a market operator, which brings together multiple third-party buying and selling interests in financial instruments in the system and in accordance with non-discretionary rules in a way that results in a contract" Scenario #2: RFQ / RFS permit quotes to be requested from discrete parties and sent directly to the requestor. Requestor must then choose which (if any) provider's quote to accept. The operator has no discretion (so it cannot be an OTF). This is arguably not an MTF: 1) Likely (although not certain) that it is multilateral as multiple parties are involved Counter-argument: The requestor interacts with each responder bilaterally (this bilateral argument is more likely to hold if the requestor must accept / reject each quote individually rather than accepting one being sufficient to automatically reject the others) 2) Possible that buying & selling interests are brought together when quotes arrive at the requestor Counter-argument: Quotes from multiple parties are not "brought together" as in a CLOB the requestor's indication of interest is brought together individually with separate quotes (i.e. there is no mass interaction of multiple requests with multiple responses) 3) Arguable that the trade might not have occurred otherwise so the system results in a contract Counter-argument: The requestor elects for a trade to occur. There is no certainty that a trade will occur on the basis of the quotes. Therefore it is not the system that "results in a contract" but instead the system enables the requestor to take an action that will "result in a contract" 11

12 Regulated Markets Regulated Market: "multilateral system which brings together or facilitates the bringing together of multiple buying and selling interests in financial instruments within the system and in accordance with its non-discretionary rules in a way that results in a contract with regard to financial instruments that have been admitted to trading in accordance with the rules and system of that market, and which operates on a regular basis and in accordance with the applicable rules on licensing and ongoing supervision" Only difference in definitions between Regulated Market and MTF is: with regard to financial instruments that have been admitted to trading in accordance with the rules and system of that market 12

13 OTFs new under MiFID II OTF: "a multilateral system 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 in accordance with Title II of MiFID II" Markets facing requirements Non-discrimination and transparency Conflicts management Monitoring compliance with the rules and orderly trading Market surveillance System resilience and tick sizes Position reporting Other differences from RM and MTFs Only for non-equities Must exercise discretion by deciding to place or retract orders on the OTF and / or deciding not to match an order with other available orders at a given point in time May facilitate negotiation between clients Client facing obligations Clients best interests Appropriate information requirements Suitability and appropriateness Best execution Prompt and fair execution of orders Publication of limit orders in shares Questions without answers (yet) Who might become an OTF? What will OTF rules look like? How much discretion will clients accept? 13

14 OTFs and trading protocols (discretion) OTF: "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" Scenario #3: Exactly the same situation as Scenario 1, however, now the platform operator has discretion as to a) if / when orders should be placed on the platform; and / or b) what orders to match against each other (i.e. follows best execution requirements - these do not necessarily equate to a price-time matching algo). Such a platform would quite clearly be an OTF under MiFID II. This is because of the reasons below except that reason (4) is now that the operator has the requisite type of discretion for the platform to be "discretionary" 1) by having multiple participants able to interact in the order book it is "multilateral"; 2) orders are "brought together" by being able to interact directly in the system; 3) orders fall within "buying and selling interests"; 4) the operator has the requisite type of discretion for the platform to be "discretionary"; and 5) because the participant cannot make a choice after submitting an order whether or not to trade, the system "results in a contract". 14

15 How to choose structure of venue as operator? You can t execute client orders against proprietary capital extent is unclear But you can deal on own account in non-liquid sovereign bonds You can t engage in matched principal trading in the same entity save for instruments other than mandatory traded derivatives but only with the client s consent If you operate an OTF You can t execute client orders against the proprietary capital of another member of the group i.e. other members of the group can t act as market makers It looks like you can operate an MTF as well (and if you re the operator of a regulated market, you can operate an MTF and OTF) Orders cannot connect to or interact with orders in an SI or another OTF so you cannot order route to SIs and OTFs 15

16 Systematic Internalisers under MiFID II Definition: An investment firm which, on an organised, frequent, systematic and substantial basis deals on own account by executing client orders outside a RM, MTF or OTF - SI is not similar to in-house matching Quantitative tests and opt in: Firms exceeding both thresholds are caught but others can opt into the regime Must notify competent authority Equities Bonds Structured Finance Products Derivatives Emission allowances Frequent and systematic basis threshold (liquid instruments) OR Number of transactions executed by the investment firm on own account OTC / total number of transaction in the same financial instrument in the EU Equal to or more than 0.4% and daily 2.5% and at least once a week 4% and at least once a week 2.5% and at least once a week 4% and at least once a week Frequent and systematic basis threshold (illiquid instruments) AND Substantial basis threshold criteria 1 OR Substantial basis threshold criteria 2 Minimum trading frequency (average during last 6 months) Number of OTC trades by investment firm in a financial instrument on own account when executing client orders of equal to or larger than in comparison to the number / nominal amount traded in that financial instrument and executed This is on own account or on behalf of clients executed on a trading venue or OTC Number of OTC trades by investment firm in a financial instrument on own account when executing client orders/ total volume / nominal amount in financial instrument executed in the EU with or on a trading venue or OTC Daily At least once a week At least once a week At least once a week At least once a week 15% 25% 30% 25% 30% 0.4% 1% 2.25% 1% 2.25% 16

17 ESMA Q&As ESMA Q&A on MiFID II and MiFIR on transparency topics Question (Section 7 - #3(3)): Are off order book trades that are reported to a regulated market, MTF or OTF under its rules excluded from the quantitative thresholds for determining when an investment firm is a systematic internaliser? A transaction is deemed to be executed on a trading venue if it is carried out through the systems or under the rules of that trading venue. There is no requirement for the transactions to be executed on an electronic order book for the trade to be subject to the trading venue s rules. Therefore, only off order book transactions that benefit from a waiver from pre-trade transparency should be considered as executed on a trading venue, and should not count for the numerator when determining whether an investment firm is a systematic internaliser. 17

18 ESMA Q&As ESMA Q&A on MiFID II and MiFIR on transparency topics Question (Section 7 - #5(c)): For how long should quotes provided by systematic internalisers be firm, or executable? The quote should remain valid for a reasonable period of time allowing clients to execute against it. A systematic internaliser may update its quotes at any time, provided at all times that the updated quotes are the consequence of, and consistent with, genuine intentions of the systematic internaliser to trade with its clients in a non-discriminatory manner. 18

19 ESMA Q&As ESMA Q&A on MiFID II and MiFIR on transparency topics Question (Section 7 - #7): For the purpose of the SI determination, when should an investment firm be considered as executing client orders when dealing on own account outside of trading venues? For the purposes of the SIs determination, ESMA considers that in all circumstances where an investment firm is dealing with a counterparty that is not a financial institution authorised or regulated under Union law or under the national law of a Member State ( financial institution ), the investment firm is deemed to be executing a client order and the transaction should count towards the calculations (both the numerator and the denominator). Where the investment firm is dealing with a financial institution, ESMA considers that one party to the transaction will always act in a client capacity. Therefore, in order to determine when an investment firm is executing client orders when dealing on own account outside of trading venues, investment firms need to assess which of the two parties to the transactions acts in the capacity of executing client orders. Investment firms may determine this either on a transaction by transaction basis or by type of transactions or type of counterparties. Different indicators could be used for determining which party executed a client order: e.g. whether an investment firm has classified the counterparty as a professional client, who initiated the trade or who received the instruction to deal and the extent to which the counterparty relied on the other party to conclude the transaction. 19

20 Commission/ESMA actions Matching arrangement An investment firm shall not be considered to be dealing on own account for the purposes of Article 4(1)(20) of Directive 2014/65/EU where that investment firm participates in matching arrangements entered into with entities outside its own group with the objective or consequence of carrying out de facto riskless backto-back transactions in a financial instrument outside a trading venue. Tick sizes SIs quotes have to essentially [ ] (iii) reflect the prevailing market conditions for that instrument. Proposal: The prices published by a systematic internaliser shall reflect prevailing market conditions where they are close in prices to quotes of equivalent sizes for the same financial instrument on the most relevant market in terms of liquidity as determined in accordance with Article 4 for that financial instrument and where the price levels could be traded on a trading venue at the time of publication. 20

21 Algorithmic trading

22 Algorithmic trading trading where a computer algorithm automatically determines parameters of orders such as whether to initiate the order, the timing, price or quantity or how to manage the order after submission, with limited or no human intervention It does not include a system only used to: route orders to trading venue(s) order processing where there is no determination of parameters other than venue order confirmation or post-trade processing of transactions It includes: automated trading decisions and optimisation of order execution by automated means systems that make independent decisions at any stage e.g. on initiating, generating, routing or executing orders 22

23 Algorithmic trading: Obligations on trading venues Internal systems and controls requirements Effective systems, procedures and arrangements to ensure algorithmic trading systems cannot create or contribute to disorderly trading conditions: Limit ratio of unexecuted orders to transactions Slow down the flow of orders if there is a risk the system capacity might be breached Limit and enforce minimum tick sizes Require members to test algorithms and provide environments for testing Manage disorderly trading conditions which do arise from algorithmic trading Ability to identify orders generated by algorithmic trading, the different algorithms used and the persons initiating orders RTS highlights Annual self-assessment on compliance with the obligations Governance and decision making framework for establishing and monitoring trading systems Adequate staff (including Compliance) with necessary skills and technical knowledge and tailored training Appropriate selection of outsourced service provider and retention of necessary expertise to supervise Due diligence on all prospective members, detailed pre-defined standards must be met Requirements for testing of new or updated trading systems prior to deployment Conformance testing with member s trading systems and algorithms Certification from members Sufficient capacity to accommodate at least twice their historical peak of messages Real-time monitoring Performance evaluation, in particular stress testing shall identify ability to respond to threats Effective business continuity arrangements Arrangements to prevent disorderly trading Mechanisms to manage volatility Pre-trade and post-trade controls 23

24 Algorithmic trading: obligations on investment firms Internal systems and controls requirements Regulatory requirements Trading systems must: be resilient and have enough capacity be subject to appropriate trading thresholds and limits prevent the sending of erroneous orders not function in a way that contributes to a disorderly market not be able to be used for any purpose that is contrary to the rules of the relevant trading venue Must have effective business continuity arrangements to deal with system failure Ensure trading systems are tested and monitored Records sufficient for competent authority to monitor compliance and kept at least 5 years Notify competent authority of home member state and trading venue Competent authority can require details of algorithmic trading strategies (and above systems and controls), and any other relevant information RTS highlights Governance and decision making framework for developing and monitoring trading systems and algorithms Adequate staff (including Compliance) with necessary skills and technical knowledge and tailored training Firms are responsible and must have necessary knowledge and documentation for any outsourced hardware or software Detailed testing and deployment requirements for algorithms leading to order execution with limited or no human intervention Annual self-assessment and validation including at least specified parameters Risk Management to create, Compliance to be made aware of any issues and senior management to approve Appropriate annual stress tests to include high message volume and high trade volume Ability to cancel unexecuted orders from any trader, desk or client and all outstanding orders Surveillance systems to monitor orders and transactions and generate alerts and reports capable of replay and ex-post analysis, covering firm s full range of trading and cross check suspicions between different activities to be reviewed at least annually and reconciliation of trading logs with others records Real time monitoring of all algorithmic trading activity including cross market, cross asset class and cross product by trader and independent Risk control function alerts within 5 seconds of event Pre-trade controls and procedures to deal with blocked trades and post-trade controls including continuous assessment of market and credit risk and reconciliations Business continuity, clear and tested communication channels, IT security Better recognition of proportionality to nature, scale and complexity of firms businesses than previous draft but detailed and comprehensive minimum standards 24

25 Direct Electronic Access

26 Delegated Regulation: direct electronic access An arrangement where a member or participant or a client of a trading venue permits a person to use its trading code so the person can electronically transmit orders relating to a financial instrument directly to the trading venue and includes arrangements which involve the use by a person of the infrastructure of the member or participant or client, or any connecting system provided by the member or participant or client, to transmit the orders (direct market access) and arrangements where such infrastructure is not used by a person (sponsored access) Delegated Regulation Critical test is ability to exercise discretion regarding exact fraction of second of order entry and lifetime of orders within that timeframe Not where it takes place through optimisation of order execution processes that determine the parameters of the order other than the venue, unless these arrangements are embedded into the clients systems and not into those of the member Why is this important? Firms using DEA cannot rely on own account dealing exemption Additional due diligence obligations Does this provide easy avoidance mechanisms? Is electronic brokerage DEA? 26

27 Direct electronic access: the chain Regulatory status Main responsibilities Authorised as RM or investment firm operating MTF or OTF Trading Venue RM, MTF or OTF Only allow member/participant/client to provide DEA if: they are authorised credit institution or investment firm they retain responsibility for orders and trades in relation to MiFID II Must be authorised credit institution or investment firm Must be a member or participant of trading venue Must notify own competent authority and that of trading venue they may require information on systems and controls Cannot be exempt by Art 2(1)(d) MiFID II but other exemptions may possibly apply e.g. Art 2(1)(j) DEA Provider would have to take into account regulatory status of DEA User Member DEA Provider Client DEA User Underlying Client DEA User? Ensure clients using DEA comply with the requirements of MiFID II and rules of trading venue Must have an agreement with trading venue setting out rights and obligations but DEA Provider must retain responsibility under MiFID II DEA Provider retains responsibility for orders submitted and trades executed through the use of its DEA systems or trading codes Monitoring and reporting to competent authority breach of MiFID II or trading venue rules, disorderly trading, market abuse Systems to ensure suitability of clients, risk controls, thresholds Controls in relation to sponsored access to be at least equivalent to direct market access Record keeping to enable competent authority to monitor compliance 27

28 ESMA Q&As ESMA Q&A on MiFID II and MiFIR on market structure topics Question (Section 2 - #24): Can DEA clients accessing an EU trading venue through sub-delegated DEA benefit from the exemption offered under Article 2(1)(d) of MiFID II? Article 4(1)(41) of MiFID II defines DEA as an arrangement where a member or participant or client of a trading venue permits a person to use its trading code so the person can electronically transmit orders relating to a financial instrument directly to the trading venue. A person who directly interacts with the member to obtain the use of the trading code will be the person granted permission under an arrangement. The DEA provider has direct knowledge of that person s use and must be taken to allow it; such a person (Tier 1 DEA client) therefore should be understood to have DEA to a trading venue. However, in some cases a DEA provider may allow a DEA user to sub-delegate the access rights onto a third entity (Tier 2 DEA client). Unlike a Tier 1 DEA client who directly interacts with the member to obtain the use of the trading code, a Tier 2 DEA client would, in most cases, not technically be in possession of the trading code of a DEA provider. The trading code is not passed down to the ultimate users of DEA, but only appended to the order message by the DEA provider before being submitted to the trading venue. Therefore, ESMA does not consider such Tier 2 DEA clients as having DEA for the purposes of Article 2(1)(d) of MiFID II. 28

29 ESMA Q&As ESMA Q&A on MiFID II and MiFIR on market structure topics Question (Section 2 - #25): Does a firm need to be authorised as an investment firm under MiFID II to provide DEA to an EU trading venue? Yes, Article 48(7) of MiFID II provides that trading venues should only permit a member or participant to provide DEA if they are investment firms authorised under [MiFID II] or credit institution authorised under Directive 2013/36/EU. Therefore, non-eu firms (including non-eu firms licensed in an equivalent jurisdiction) or EU firms without a MiFID II licence are not allowed to provide DEA to their clients. This applies regardless of where the clients using the DEA service are located. 29

30 Direct electronic access: obligations on trading venues Internal systems and controls requirements RTS Effective systems procedures and arrangements to ensure members can only be DEA providers if they are IFs or credit institutions Set appropriate criteria regarding the suitability of persons to whom access may be provided Ensure that members retain responsibility for order entered through DEA Set appropriate standards regarding risk controls and thresholds on trading through DEA Ability to distinguish, and stop, order sent through DEA separately from orders from a member Ability to suspend or terminate the provision of DEA by a member in the case of non-compliance Make public conditions pursuant to which members are able to provide DEA to their clients Make SA subject to TV authorisation and same pre-trade risk limits and controls for IFs accessing through SA as to members Security and limits to access 30

31 Direct electronic access: obligations on investment firms Internal systems and controls requirements Documentation requirements Regulatory requirements RTS Ensure proper assessment and review of suitability of clients using the service Clients are prevented from exceeding pre-set trading and credit thresholds Proper monitoring of trading by clients Appropriate risk controls to prevent: risks to investment firm creation or contribution to disorderly markets breaches of the market abuse regime breaches of the rules of the trading venue Records sufficient for competent authority to monitor compliance at least 5 years Binding written agreement with the client Investment firm must retain responsibility for its compliance with MiFID Competent authorities of home member state and trading venue Competent authority can require description of the systems and controls and evidence that they have been applied DEA providers are responsible for client trading need procedures to ensure compliance Undertake due diligence minimum requirements but as appropriate to risks posed by nature of clients and their activities annual risk based reassessment of client systems and controls If user can sub-delegate, provider must ensure user has equivalent due diligence framework Pre- and post- trade controls including automatic rejection of orders outside certain price and size parameters and ability to stop order flow and monitor on ongoing basis Ability to identify each DEA user and, where sub-delegated, each order flow 31

32 General clearing members Internal systems and controls requirements Effective systems and controls so that clearing services are only applied to suitable persons whom meet the criteria Impose appropriate requirements on those persons to reduce risks to the IF and the market Documentation requirements RTS Binding written agreement with the client Systems used to provide clearing services subject to appropriate due diligence, controls and monitoring Perform due diligence on clients Set trading and position limits to their clients and monitor clients' positions against limits Public disclosure of conditions applicable to clients, incl. level of protection and costs 32

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