MiFID II to Transform Markets

Terry Flanagan

EU proposals place restrictions on algorithmic and high-frequency trading, and force many derivatives to be traded on exchanges.

The European Commission’s proposals on Markets in Financial Instruments Directive (MiFID II), which were published Thursday, extend the original MiFID’s scope beyond equities to require that OTC derivatives be traded on central exchanges.

They also define a new category of organized trading facility (OTF), broadly defined to capture all types of organized execution and arranging of trading—such as broker-operated dark pools and crossing networks–that don’t correspond to the functions of existing venues.

Taking note of the growth in the use of algorithmic and high-frequency trading strategies, MiFID II includes a controversial market-making obligation.

The directive requires that “an algorithmic trading strategy shall be in continuous operation during the trading hours of the trading venue to which it sends orders or through the systems of which it executes transactions. The trading parameters or limits of an algorithmic trading strategy shall ensure that the strategy posts firm quotes at competitive prices with the result of providing liquidity on a regular and ongoing basis to these trading venues at all times, regardless of prevailing market conditions.”

MiFID II, along with European Market Infrastructure Regulation (EMIR), which has been approved by the Council of the European Union, will mandate new platforms for derivatives that are currently traded over-the-counter and via broker-crossing networks, much like Dodd-Frank created the SEF [swap execution facility] in the United States.

MiFID II will require that CCPs provide non-discriminatory access to clearing of financial instruments. Regardless of the trading venue on which a transaction is executed.

Concomitantly, it will require trading venues to provide trade feeds on a non-discriminatory basis upon request to any CCP that wishes to clear financial transactions executed on that venue.

Taken together, MiFID and EMIR address a multitude of regulatory issues brought on by the financial crisis, last year’s flash crash, and automation.

The overarching objective of the original MiFID framework was to further the integration, competitiveness and efficiency of European financial markets, including the introduction of a well calibrated post-trade transparency regime for OTC derivatives.

However, the International Swaps and Derivatives Association is concerned that the European Commission’s stance on organized trading of OTC derivatives goes well beyond the spirit of the September 2009 G20 commitment that OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate.

In particular, the European Commission proposes certain restrictions on OTFs that will hurt end user choice and market liquidity, ISDA said.  These restrictions would, in essence, limit the types of trades that can be transacted on single dealer platforms and would adversely affect the ability of firms to effectively manage their risks.

Under MiFID II, the European Securities and Markets Authority (ESMA) will be given broad powers to determine which derivatives get traded on organized trading platforms, such as regulated markets, MTFs, or OTFs.

In developing implementing technical standards, ESMA will make a determination based on the average frequency of trades, the average size of trades, and the number and character of active market participants.

OTC derivatives trade infrequently. For example, only 3,600 interest rate swaps are traded each day globally and only half of these are sufficiently standardized to be cleared, according to ISDA.

In all, less than 1,000 interest rate swaps will be traded in Europe on OTFs, ISDA said. Half of these may be interdealer trades and the balance will be divided across hundreds of infrequently traded contracts with different maturities.

“These trades depend on the ability of dealer firms to make markets, particularly given the large trade size of most interest rate swaps,” said Conrad Voldstad, ISDA’s CEO.  “If you want to protect end users’ ability to access these markets, then you need a suitable range of venues on which to trade; limiting what you class as an eligible trading platform for OTC derivatives is not a good move.”

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