Equity Market Users Urge MiFID II Policymakers to Tread Carefully on OTFs

Terry Flanagan

With the Markets in Financial Instruments Directive (MiFID II) regulatory review, which is proposing a huge shift in the way financial markets operate in Europe, currently held up in Brussels due to political wrangling, market participants are still none the wiser as to how the European equities trading landscape will look once the dust has settled.

“The hot topic at the moment is broker crossing networks,” Paul Squires, head of trading at Axa Investment Managers, told Markets Media.

In July, European parliamentarians on the Economics and Monetary Affairs Committee (Econ) postponed a vote on MiFID II after Econ had tabled over 2,000 amendments to it. One of the main bones of contention was the potential creation of a new type of trading venue, to be called an organized trading facility (OTF), and whether or not broker crossing networks will be classified as an OTF, or something else, under MiFID II.

Markus Ferber, a German center-right MEP and member of Econ, who is responsible for guiding MiFID II through the European parliament, today told Markets Media that the creation of an OTF is “fundamental” and does not want see a future for less-regulated broker crossing networks operating in Europe. However, Arlene McCarthy, a left-of-center U.K. MEP who is also vice-chair of Econ, has said previously that she wants the OTF category removed as it is not well enough defined and would create another type of player to enter an already complex market. She would like to see all venues classed as either a regulated exchange or a multilateral trading facility.

Market participants will know one way or another the likely fate of OTFs, and also broker crossing networks, in about two weeks’ time when Econ is likely to finally vote on the matter. But it appears now that OTFs could be here to stay under MiFID II and broker crossing networks re-categorized.

“[It is] whether [broker crossing networks] are allowed to become OTFs or whether there will be an OTF category for equities at all,” said Squires.

Crossing networks, which are run by broker-dealers, were not categorized under the original three exchange classifications under the original MiFID rules back in 2007 and have operated as over-the-counter ever since. The three categories of MiFID trading venue are either a regulated market for the existing exchanges, an MTF for venues that bring together buyers and sellers in a non-discretionary way and have been described as a form of ‘exchange lite’, and the little-used systematic internalizer, which is used for firms that execute orders from clients against its own book or against orders from other clients.

However, Ferber today told Markets Media that OTFs should be added to the list of the three current exchange types under the original MiFID rules and that broker crossing networks could fit into any of the four resulting categories apart from a systematic internalizer. This, though, is still not set in stone as the vote has yet to take place.

Broker crossing networks do not show an order book and simply aim to match orders; due this nature they are sometimes compared to dark pools, which have similar characteristics, but they are classified as MTFs.

A number of investment banks in the European Union operate broker crossing systems that match client order flow internally, such as Citigroup, Credit Suisse, Deutsche Bank, JP Morgan, Morgan Stanley and UBS. Generally, these firms receive orders electronically, utilize algorithms to determine how they should best be executed, given a client‘s objectives, and then pass the business through an internal system that attempts to find matches. Some systems match only client orders, while others also provide matching between client orders and house orders.

“We would start off by saying an OTF in equities is definitely a good thing,” said Squires at Axa. “Within that, we don’t mind if broker crossing network flow is only allowed to be categorized as an OTF if it is agency-only flow. Anything that has a principal element to it may be excluded from an OTF category. We wouldn’t mind that because it gives a cleaner, if smaller, universe of flow dropping into an OTF category. But the brokers are very concerned about that.”

A major buy-side industry body, the European Fund and Asset Management Association (Efama), is also critical of the possible plans to ban the OTF category for equities.

“[The ban] will lead to difficulties for execution of large orders,” said Christian Dargnat, chief executive of BNP Paribas Asset Management and vice-president of Efama.

“Crossing networks provides the match of buy and sell order at the mid-price and provide a protection against the high-frequency trader and short-term speculators.”

The revised MiFID II proposals, which are all about increasing transparency and competition in the market place, are likely to force the broker-dealer banks to change their business models with some already looking at establishing new internal trading venues that will allow them to operate within the new rules.

The traditional incumbent exchanges are strongly opposed to the setting up of what they see as the less regulated OTF category and that it will lead to a less level playing field.

“Exchanges are critical of the OTF proposals because brokers running these multilateral venues would be able to avoid some of these rules, in particular the non-discretionary execution,” Judith Hardt, secretary-general of the Federation of European Securities Exchanges, which lobbies on behalf of 46 of the region’s exchanges, told Markets Media earlier this year. “This would allow bank crossing networks to offer better outcomes to some of their clients.”

Any final vote by Econ on MiFID II will surely alienate some section of the market but, because of the lengthy delays, the new legislation is not likely to be in force now by 2015 at the earliest. Other contentious issues still to be decided upon in the equities sphere include pre-trade transparency waivers and measures to limit high-frequency trading.

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