THE INVESTMENT ASSOCIATION POSITION PAPER ON INTERNAL CROSSING BY ASSET MANAGERS SUMMARY One of the key objectives of MiFIR/D II is to ensure that trading in financial instruments is carried out in so far as possible on organised venues and that all such venues are appropriately regulated. This follows concern from regulators that some of the trading venues that developed under MiFID I were not adequately captured by the regulatory regime. In particular MiFIR/D II has sought to bring into scope broker crossing networks to ensure that they are properly regulated and authorised under one of the types of multilateral trading venues or as systematic internalisers under the related conditions. However, the Investment Association (IA) is concerned that if the MiFIR/D II provisions are not appropriately interpreted. Both in terms of the spirit and letter of the legislation, the provisions that were intended for broker crossing networks ( BCNs ) could capture the type of inter and intra fund transfers that asset managers in the EU undertake. This will significantly impair our members ability to continue undertaking these transfers (also referred to as internal crossing) and will impact their ability to continue meeting their best execution obligations. From a longer term perspective, we are concerned that an inappropriate extension of the regulatory requirements that are specifically targeted at BCNs will place the EU asset management industry at a competitive disadvantage, particularly with regard to asset managers in jurisdictions whose regulators have long appreciated the benefits of internal crossing in limiting transaction costs to end clients. ORGANISATIONAL REQUIREMENTS It is the IA s view that the organisational requirements under Articles 18 1, 19 2 and 20 3 of MiFID II should not be applied to asset managers. Firms that internally cross trades: do so in an agent capacity on behalf of their clients on both sides of the trade. This means that asset managers cannot be considered to be investment firms undertaking matched principle transactions on a regular basis, an activity that requires authorisation as a multilateral trading facility (MTF) 4. only do so for funds that they manage and thus fail to meet the requirement for MTFs and OTFs to have at least three materially active members or users 5 provide both the buy and the sell side of the order. This means that there is no extra liquidity coming to market for anyone to take advantage of. As such, these trades do not contribute to the price discovery process. 1 Article 18 Trading Process and Finalisation in an MTF and an OTF Markets in Financial Instruments (MiFID II) 2 Article 19 Specific Requirements for MTFs 3 Artile 20 Specific Requirements for OTFs 4 Recital 19 of the Delegated Regulation supplementing Directive 2014/65/EU of the European Parliament and of the Council as regards organisational requirements and operating conditions for investment firms and defined terms for the purposes of that Directive 5 Article 18 (7)
are not remunerated on a transaction basis via commission or spread. Instead the service is a value-add under fees payable on assets under management. SHARE TRADING OBLIGATION In addition to the above, we do not believe that cross-trades should be subject to the share trading obligation under Article 23 of MiFIR. Whilst we welcome the exemptions provided under RTS 1 for transactions executed by AIFMs and UCITS managers, this exemption will not apply to investment firms providing MiFID portfolio management services. Further intra-fund transfers, even those managed by AIFMs and UCITS managers will not always result in the transfer of ultimate beneficial ownership of shares from one collective investment undertaking to another. PROPOSED SOLUTION To address these concerns we propose that ESMA sets out criteria with regard to how asset managers operating or domiciled in the EU may internally cross fund flows where these are perfectly matched positions, (and in practice) do not contribute to the public price discovery process and where the asset manager has given careful consideration to its fiduciary duty and best execution obligations. In addition, we would welcome clarification that where brokers execute cross trades for the same client, this activity will not be considered to be undertaken on a multilateral basis and that the broker will not be required to register as operating an MTF. In this paper we set out: why asset managers internally cross their clients buy and sell orders; the process for internal crossing; regulatory implications on asset managers who undertake internal crossing; and proposed solutions to these concerns. RATIONALE FOR INTERNAL CROSSING Internal crossing by an asset manager is undertaken to: reduce market risk by reducing market exposure; ensure that best execution obligations are met; and ensure that clients do not incur broker commissions, fees or charges, thus saving them from transaction costs. Transaction costs are inextricably linked with the process of investing in order to generate a return on behalf of clients. By taking advantage of opportunities to match clients buy-and sell-orders, an asset manager can generate significant cost savings in explicit and implicit transaction costs for the clients in the funds involved. Explicit transaction costs involve payment of brokerage commissions and charges and implicit costs include the bid-ask spread, which covers order processing and asymmetrical information costs. Other indirect costs may include market impact costs, delay costs and the opportunity costs of unexecuted trades. Transaction costs vary depending on a number of factors, such as the type of security, daily trading volume in the security, the size of the order being processed, market conditions and the geographic location of the transaction. As asset managers typically have a long-term horizon, the aforementioned transaction costs therefore, can compound to the extent that they become a significant drag on fund performance, to the detriment of end clients. 2 of 16
PROCESS OF INTERNAL CROSSING Opportunities for crossing trade arise when an asset manager matches buy- and sell-orders for both equity and fixed income securities held in the funds managed by the asset management company. These transfers can be: Inter-fund from one fund to another with a change of beneficial owner; or Intra-fund from one fund to another, or from one of sub-fund of a fund to another sub-fund of the same fund, without a change of the ultimate beneficial owner. A cross trade can be executed: Internally through the firm s central desk. The firm will then instruct the custodian of the client/fund which is the seller to transfer the security and for the custodian of the client/fund which is the purchaser to make the cash payment. The asset management firm will then report the transaction. 6 Externally through a broker after the firm s central dealing transmits an order to be crossed at a pre-determined price (last price or mid-market price). The broker will then report the transaction and send the confirmations. Typically these cross trades occur without any commission payment to the broker. 7 INTER-FUND TRANSFERS Inter-fund transfers can only be done if the investment mandate permits this activity and if the legal framework governing the fund structure allows for the exchange of assets between two accounts without going through a public market. Inter-fund transfers are reported under the MiFID I trade reporting requirements. These transfers can be undertaken either by: Two portfolio managers in different investment centres as part of a global asset management company of behalf of various clients/funds (eg. London and New York). 8 Two portfolio managers in the same investment centre on behalf of various clients/funds. 9 One portfolio manager on behalf of two funds that s/he manages for various clients. PROCESS The process for inter-fund transfers will vary from one asset management company to another. However, every firm will have clear policies and procedures in place that will include: Policies describing the criteria that will be applied by the manager in determining that executing a securities transaction as an inter-fund transfer will be beneficial to both parties in the transaction; Processes to ensure that any conflicts of interest of the parties that are involved in the inter-fund transfer are managed; Processes to determine the appropriate price for the inter-fund transfer to occur; Details on the compliance oversight of all inter-fund transfers; and Record keeping requirements for all inter-fund transfers. 6 See Appendix, scenario 1 7 See Appendix, scenario 2 8 See Appendix, scenario 3 9 See Appendix, scenario 4 3 of 16
Criteria Opportunities for inter-fund transfers are identified in a number of ways depending on the firm s specific process. Such methods include: Through the firm s order management system which would flag a crossing opportunity to the central dealing desk. Based on the firm s policies and approval procedures the central dealing desk will determine whether it is appropriate to undertake an interfund transfer or put the order through the market. By portfolio managers seeking out opportunities within their teams to undertake an inter-fund transfer. Based on the firm s policies and approval procedures the portfolio managers will provide a rationale for why they believe the internal cross trade is to the benefit of their clients, prior to transmitting orders to their central dealing desk for execution. By portfolio managers specifically requesting the central dealing desk to seek out an opportunity for an inter-fund transfer prior to putting the order to market. All inter-fund transfers are subject to best execution obligations Price Determination A number of different factors will be taken into account when determining an appropriate market price for the cross to occur, which are subject to compliance verification. Rule 17a-7 of the 1940 Investment Companies Act (40 Act) in the US states that current market price shall be: If the security is an NMS stock 10 the last price that was reported on a consolidated transaction reporting system or the average of the highest current independent bid and lowest independent offer for such a security if there are no transactions reported to the consolidated system; or If the security is not a reported security and the principal market for the security is an exchange, then the price of the last sale of the exchange, or the average of the highest current independent bid and the lowest independent offer on the exchange if there are no reported transactions on the exchange that day. For all other securities, the highest current independent bid and lowest current independent offer determined on the basis of reasonable enquiry. In practice, for equities, the following prices can be used subject to internal policies and procedures: Last price for 40 Act clients due to the Rule 17a Restrictions. Last price for index/tracker funds after the market is closed. Last price in markets where there is no meaningful bid-offer price or volume. Volume Weighted Average Price may be used in illiquid markets. Mid-market price. If mid-market price cannot be achieved then a price closest to mid will be used. In fixed income: For liquid instruments the established mid-price will be used. For illiquid instruments: o as much data will be collected to create an average eg. 3 best bid/3 best offers; o an independent mid-price may be used; or o where a bid/offer is not available a cross may be permitted where there is a detailed rationale for a trade, the traded price does not have a deviation 10 Ie. National Market Systems such as NYSE or NASDAQ etc. 4 of 16
greater than a set percentage from the last available market price, and signoff is received from senior management. The cross trades are then executed either through the central dealing desk or through a broker. INTRA-FUND TRANSFERS Intra-fund transfers are those that involve the transfer of securities from one fund to another, or from one of sub-fund of a fund to another sub-fund of the same fund, without a change in the ultimate beneficial owner. This can be done by crossing buy and sell orders from: Two portfolio managers in different investment centres that form part of an insurance group managing funds for two different parent company entities, where there is no change in the legal or beneficial owner at group level (eg. PMs in London and New York, managing funds for 2 subsidiary companies one US, one UK - both owned by the same UK Plc). 11 Two portfolio managers in different investment centres on behalf of the same client/fund (eg PMs in London and Frankfurt on behalf of an insurance company client). Two portfolio managers in the same investment centre on behalf of the same client/fund (eg. PMs in London on behalf an insurance company client). 12 One portfolio manager on behalf of two funds that s/he manages for the same client/fund. 13 The cross trades are then finalised through the back office as book keeping entries. REGULATORY CONCERNS INTERNAL CROSS TRADES The IA does not believe that MiFIR/D II requirements were designed to capture that type of internal crossing that asset managers undertake, as highlighted in the previous section. It is our view that the intention of the Regulation is to capture trading systems that developed under MiFID I. As noted in Recital 6, any trading system in financial instruments, such as entities currently known as broker crossing networks, should in the future be properly regulated and be authorised under one of the types of multilateral trading venues or as a systematic internaliser under the conditions set out in MiFIR. However, asset managers as agents do not and cannot run broker crossing networks which typically encompass both client and proprietary trading. It is our view that the organisational requirements under Articles 18 14, 19 15 and 20 16 of MiFID II should not be applied to asset managers because firms that undertake internal cross trades: do so in an agent capacity on behalf of their clients on both sides of the trade. This means that asset managers cannot be considered to be investment firms undertaking 11 See Appendix, scenario 5 12 See Appendix, scenario 6 13 See Appendix, scenario 7 14 Article 18 Trading Process and Finalisation in an MTF and an OTF Markets in Financial Instruments (MiFID II) 15 Article 19 Specific Requirements for MTFs 16 Artile 20 Specific Requirements for OTFs 5 of 16
matched principle transactions on a regular basis, an activity that requires authorisation as a multilateral trading facility (MTF) 17 ; only do so for funds that they manage and thus fail to meet the requirement for MTFs and OTFs to have at least three materially active members or users 18 ; provide both the buy and the sell side of the order. This means that there is no extra liquidity coming to market for anyone to take advantage of. As such, these trades do not contribute to the price discovery process, particularly if the trade executed at the mid or closing price where those prices are available; are not remunerated on a transaction basis via commission or spread. Instead the service is a value-add under fees payable on assets under management. We are concerned that if the MiFID II provisions are not appropriately interpreted they will significantly impair our members ability to continue to carry out internal crossing. This will not only have implications on our members ability to continue to meet their best execution obligations, but will result in a significant increase in cost of investing to their end clients. BROKER CROSS TRADES We note that a significant proportion of the asset management industry undertakes their internal crossing through a broker by giving the broker both the buy and sell order. This will give rise to a matched principle trade (back-to-back trade) for the broker, not the asset manager. These cross trades will typically be directed to one of the asset manager s largest counter-parties and are typically executed without any commission payment. However, once MiFIR/D II comes into force it is unlikely that brokers will continue to provide this service to the asset management industry if they want to act as an SI broker in equities (or particular non-equity securities). Recital 19 of MiFIR states that a systematic internaliser should not consist of an internal matching system which executes client orders on a multilateral basis, an activity which requires authorisation as a multilateral trading facility (MTF). An internal matching system in this context is a system for matching client orders which results in the investment firm undertaking matched principal transactions on a regular and not occasional basis. Asset managers do have the option to utilise a non-si broker (acting in an agency capacity) or third party venue to undertake their cross trades and this would involve a commission payment. However, Rule 17a of the SEC Investment Company Act of 1940 expressly states that a cross trade can only occur provided that no brokerage commission, fee (except for customary transfer fees), or other remuneration is paid in connection with the transaction. This is broadly interpreted across the industry both in the US and Europe to mean that asset managers are prohibited from paying any commission for cross trades. This inability to pay commission for asset managers that currently manage 40 Act funds basically means that the option to use non-si brokers to cross trades is not available to them, putting such asset managers and their clients at a significant disadvantage. As a result, asset managers these transactions will have to be execute in the market giving rise to significant transaction costs (including market risk costs). SHARE TRADING OBLIGATION The IA does not believe that cross-trades should be subject to the share trading obligation under Article 23 of MiFIR. Whilst we welcome the exemptions provided under RTS 1 for transactions executed by AIFMs and UCITS managers, this exemption will not apply to investment firms providing MiFID portfolio management services. 17 Recital 19 of the Delegated Regulation supplementing Directive 2014/65/EU of the European Parliament and of the Council as regards organisational requirements and operating conditions for investment firms and defined terms for the purposes of that Directive 18 Article 18 (7) 6 of 16
In addition, we note that intra-fund transfers, even those managed by AIFMs and UCITS managers will not always result in the transfer of ultimate beneficial ownership of shares from one collective investment undertaking to another. PROPOSED SOLUTION To address these concerns we propose that ESMA set out criteria with regard to how asset managers operating or domiciled in the EU may internally cross fund flows where these are perfectly matched positions, (and in practice) do not contribute to the public price discovery process and where the asset manager has given careful consideration to its fiduciary duty and best execution obligations. These criteria could include: 1. The execution takes place with reference to the current market price; 2. No brokerage commission, fee or other remuneration is paid by the client(s); 3. Careful consideration is given to the asset manager s fiduciary duty of care and its best execution obligations; 4. Both client mandates allow for internal crossing; 5. The asset manager maintains and preserves permanently in an easily accessible place a written copy of its internal crossing procedures; 6. The asset manager keeps a record of all transactions executed via internal crossing including a description of the security bought or sold and the terms of the purchase or sale; and 7. The asset manager must treat both side of the cross equally and fairly. These criteria may be adopted by ESMA through level-iii guidelines or Q&As to ensure a level playing field across Europe. In addition, we would welcome clarification that where brokers execute cross trades for the same client, this activity will not be considered to be undertaken on a multilateral basis and that the broker will not be required to register as operating an MTF. April 2017 7 of 16
APPENDIX EXAMPLES OF INTERNAL CROSSING PROCESSES These examples represent just some of the ways in which EU asset managers internally cross. This should therefore be viewed as a non-exhaustive list of current practices. SCENARIO 1 MULTI-ASSET CLASS, INTER-FUND, INTERNAL CROSS 8 of 16
SCENARIO 2 EQUITY, INTER-FUND, BROKER CROSS 9 of 16
SCENARIO 3 EQUITY, INTER-FUND, INTERNAL CROSS Fund A (UK Asset Manager) wishes to sell. All clients must have given prior approval to be involved in a cross trade. An appropriate rationale for a Cross Trade is entered into the system. The cross is established on an arm s length basis*. Establish whether cross is allowable. Some jurisdictions don t allow it. If not, buy and sell on exchange If allowable, cross via a broker, paying a small commission Cross Trade will usually be done at mid price. For illiquid markets VWAP may be used. Closing price may be used in markets where there is no meaningful bid/offer price or volume, or for Index/Tracker funds when the market is closed. Closing price must be used for US clients, although if the price is unfair the dealers may work orders arms-length in the market. Cross completed Trade reviewed by Compliance the following day. 10 of 16
SCENARIO 4 FIXED INCOME, INTER-FUND, INTERNAL CROSS 11 of 16
SCENARIO 5 MULTI-ASSET, INTRA-FUND, INTERNAL CROSS Ultimate beneficial owner (UK PLC) Subsidiary client (UK) Subsidiary client (overseas) UK asset manager Cross identified between non-ucits/aifmd funds with same ultimate beneficial owner. Cross completed internally at the close. 12 of 16
SCENARIO 6 MULTI-ASSET, INTER OR INTRA-FUND, INTERNAL CROSS UK Portfolio manager Process is largely automated and takes place entirely on the dealing desk UK Portfolio manager US portfolio manager US portfolio manager UK Asset Manager System indicates potential cross. The crosses may be intrafund (same beneficial owner) or inter-fund (different beneficial owners). Binary eligibility test to ensure both funds can cross in a given market. Pricing based on last sale price. Cross completed. Allocations calculated so as to minimise transactions. Hong Kong portfolio manager Japanese portfolio manager 13 of 16
SCENARIO 7 MULTI-ASSET, INTRA-FUND, BROKER CROSS 14 of 16
SCENARIO 8 EQUITY, INTER-FUND, BROKER CROSS 15 of 16
SCENARIO 9 FIXED INCOME, INTER-FUND, BROKER CROSS 16 of 16