The dramatic increase over the past decade in the percentage of trading that is carried out electronically has given rise to a plethora of technology providers offering a range of services across the trade workflow. While the electronification of the industry presented firms with many benefits, it also created a new challenge; how to differentiate multilateral from bilateral trading, especially when third parties are involved. Electronification added complexity to an already complex marketplace and has made it difficult to determine the trading venue perimeter boundary. This poses a significant regulatory risk to financial services firms and technology providers which, without realising, may be operating a de-facto trading venue.
By: GreySpark’s Keith Lagrange, Manager
To ensure legal certainty and avoid divergence in the practical application of the market structure regulatory framework, in March 2021, the European Securities and Markets Authority (ESMA) published its review report on the functioning of Organised Trading Facilities (OTF). The report includes a definition of what constitutes an OTF, considers the definition of a multilateral system and the boundaries of the trading venue authorisation perimeter, and includes a proposal for an opinion on the boundary line. Subsequently, market participants were invited to comment on the proposal, issued in a consultation paper, before the deadline of 29 April 2022.
The consultation paper aimed to clarify the definition of a multilateral system, and the trading venue perimeter, considering the following:
● Technology Providers;
● Communication Tools;
● Order Management Systems (OMS);
● Execution Management Systems (EMS); and
● Request for Quote Systems (RFQ)
In this article, written to help investment firms and technology providers ‘untangle the trading venue perimeter’, GreySpark Partners assesses ESMA’s current position as to what constitutes a trading venue, considers the characteristics of a multilateral system – specifically, where the line is drawn between technology provider and trading venue – and reviews the positions taken in the UK post-Brexit and in the US.
Defining a Multilateral System
A Multilateral System is defined as any system or facility in which multiple third-party buying and selling trading interests in financial instruments can interact in the system.
The system is technology agnostic and can be better described as a set of rules that govern how third-party interests interact, and MiFID II mandates that all multilateral systems must operate under a trading venue authorisation, as either a Regulated Market (RM), MTF or OTF. There are four components to a multilateral system, as defined by ESMA, and these include that:
1. It is a system or facility;
2. There are multiple third-party buying and selling interests;
3. Those trading interests can interact; and
4. The trading interests are in financial instruments that are within the scope of MiFID II.
MiFID I: Defined a trading venue as a multilateral system that operates in accordance with non-discretionary rules, bringing together buying and selling trading interests that result in a contract. Two types of trading venues were defined:
- Regulated Market (RM); and
- Multilateral Trading Facility (MTF).
MiFID II: Introduced an additional type of trading venue, an Organised Trading Facility (OTF), which was intended to capture multilateral systems, which brought together buyers and sellers, using discretion to match their orders and, therefore, not captured by MiFID I.
Regulated Market: Run by a market operator, such as the London Stock Exchange.
Multilateral Trading Facility: Run by an investment firm or market operator for trading instruments such as: cash equities, commodities, currencies, exchange traded funds (ETF’s) and futures.
Organised Trading Facility: Run by an investment firm for trading instruments such as: bonds, structured finance products, emission allowances and derivatives.
ESMA’s definition of a ‘third-party’ (Section 5.2, Paragraph 17) includes third-party system operators, such as investment firms and market operators, as well as third-party APIs. Traditionally, EMS & RFQ systems were viewed as bilateral systems, however, ESMA states that:
“In scope are also systems where only two trading interests interact, provided such trading interests are brought together under the rules of a third-party operator” (Section 3.1, Paragraph 24)
Therefore, if the trade that results from such a transaction is bilateral, the fact that it is brought together by a third-party operator would be enough to trigger the trading venue authorisation requirements.
The Trading Venue Perimeter and its Application to Technology Providers
In its consultation paper, ESMA acknowledged that the rise of technology providers has caused an inconsistent view of what constitutes a multilateral system within the context of communication tools, OMS, EMS and RFQ systems, which is leading to an unlevel playing field between trading venues, technology providers and investment firms. ESMA presented its view on the application of the trading venue perimeter in respect of those systems in an attempt to clarify the boundary line for each type of system.
Over the last few years in particular, communication tools have undergone a rapid evolution such that many now incorporate a range of additional services, including market data provision, RFQ management, trade inventory and, more recently, trade execution. This increased functional scope has added layers of complexity to those tools, making it difficult to determine whether such platforms can still be considered to be primarily a communication and / or information tool, or whether it is operating as a de facto trading venue. ESMA states, in its consultation paper, that a lack of genuine trade execution or trade arrangement is what separates a communication tool from a trading venue.
“There needs to be genuine interaction (for example by including a button, or by providing the ability to communicate) where the intention to enter into a transaction can be confirmed between the users of such platform in order for it to qualify it as a multilateral system.” (Section 4.1.1, Paragraph 44)
ESMA further states that the characteristics of a bulletin board are important to understand when differentiating between a communication tool and trading venue. These characteristics include that:
- the system consists of an interface that only aggregates and broadcasts buying and selling interests in financial instruments;
- the system:
○ does not allow for the communication / negotiation between advertising parties, and this includes notifications of any potential matches between buying and selling interests in the system; and
○ does not impose the mandatory use of tools of affiliated companies; and,
- there is no possibility of execution or the bringing together of buying and selling interests in the system.
Therefore, it is the characteristics of the system, and not the technology used, that are important when determining whether to seek authorisation as a trading venue, as shown in Figure 2.
Order Management Systems
ESMA describes OMS systems as inward looking and used to direct orders to internal traders for execution.
“The main goal of such systems seems to be the structuring of the order flow and the possibility to easily follow up the lifecycle of orders. OMS appears to be an inward-looking tool, which helps companies to keep track of holdings and provide some automation to the order submission system.” (Section 4.1.2, Paragraph 49)
Therefore, provided third-party interests are not brought together, an OMS system falls outside of the trading venue perimeter. ESMA does, however, state that each system will need to be assessed on a case-by-case basis, taking the four elements described in Figure 1 into account.
Execution Management Systems
ESMA differentiates between two different categories of EMS Systems:
- Those that facilitate trade execution within trading venues; and
- Those that facilitate trade execution outside of a trading venue
In the first category, the EMS is operated by the investment firm and is used to aggregate information from trading venues, to determine the best venue for execution. In this example, the EMS falls outside of the trading venue perimeter. This conclusion is based on the lack of third-party interaction within the system.
Conversely, in the second example, the EMS routes orders to counterparties instead of trading venues for execution, ESMA states this might, under certain circumstances, be considered multilateral in nature, depending on the specific features and level of complexity. While ESMA does not definitively state that such systems are multilateral, it does state that further guidance should be sought regarding such systems. Furthermore, systems operated by a third-party should be subject to closer scrutiny from the regulator, as shown in Figure 3.
ESMA provides three examples of RFQ systems:
1. Those systems as described in the MiFID II’s Regulatory Technical Standards (RTS 1 and RTS 2) (Figure 4):
“Trading systems where a quote or quotes are provided in response to a request for quote submitted by one of more members or participants.” (Section 4.2, Paragraph 58)
2. Single Dealer Platform (SDP) operated by an investment firm (Figure 5); and
3. Single Dealer Platform (SDP) operated by a third-party (Figure 6).
Those three systems are described as follows.
Figure 4 illustrates a multilateral platform. ESMA states the very nature of such systems is to bring together third-party buying and selling interests and to connects clients with dealers. The key determining factor which makes such systems multilateral is that they bring multiple clients together in the system, which provides access to dealers. Therefore, according to ESMA, these systems are multilateral and require authorisation as a trading venue.
In an SDP (Figure 5), the key differences are that:
● Clients can only interact with one bank (it does not bring together multiple interests);
● The bank is the owner and operator of the system;
● The bank never initiates the request; and
● The bank deals on its own account.
Based on these characteristics, and the fact that the four components described in Figure 1 are not present, this system is not a multilateral facility requiring a trading venue authorisation.
Finally, as illustrated in Figure 6, an SDP operated by a third party has the same characteristics as an SDP other than its operator type. ESMA states:
“The bilateral nature of a system cannot refer only to the parties that agree on the transaction and disregard the operator of the trading system.” (Section 4.2, Paragraph 70)
So, where the system operator of an SDP brings together third-party interests, even those of a single counterparty, and does not deal on own account, it must be regarded as a multilateral system and seek authorisation as a trading venue.
Trading Venue Perimeter Outside of the European Union
The opinions outside the jurisdiction of the European Union on the trading venue perimeter boundary are of interest to multinational trading organisations.
On 1 March 2022, the UK published a consultation paper in which the ambiguity of the trading venue perimeter was recognised. Most respondents agreed that the MiFID II definition of multilateral systems created uncertainty about the perimeter, especially given the rise of technology provider platforms which bring together buyers and sellers. In its response, the UK government recognised the need for further clarity and agreed that this would come in the form of regulatory guidance, and not in a change to the current legislation. This guidance is expected from the Financial Conduct Authority (FCA); however, no date has been set at the time of writing.
United States of America
A recent staff advisory on the activities that may trigger SEF registration requirement indicate that the US is taking a broad-based interpretation of what constitutes a Swap Execution Facility (SEF).
The parameters of a SEF include that it is:
1. A system that facilitates trading or execution of swaps through one-to-many or bilateral communication;
2. A system that facilitates trading or execution of swaps not subject to the trade execution requirement;
3. A system that provides non-electronic means for the execution of swaps; and
4. A system that is currently registered with the Commodity Futures Trading Commission (CFTC) in some other capacity, such as a commodity trading advisor or an introducing broker, if its facility falls within the SEF definition.
Point 1 is of particular interest as it brings platforms which act as a single source of liquidity (one-to-many) into scope. Many providers of such platforms had previously argued that their platforms were out of scope as they did not meet the many-to-many requirement. The staff advisory effectively closes this loophole by affirming that the multiple-to-multiple prong is met by having the ability to execute swaps with multiple participants.
Implications of ESMA’s Trading Venue Perimeter Definition on the Fixed Income Markets
In recent years, the fixed income market, traditionally a bilateral voice-driven request-for-quote dominated market has moved progressively toward an electronic trade execution model. Consequently, the impact of ESMA’s definition of the trading venue perimeter will be felt increasingly strongly.
As the revised definition of the trading venue perimeter will bring into scope several technology vendors, there may be additional costs the industry will have to bear. The wider concern is that these costs will not only be passed on to clients in the form of execution costs, but also that innovation will be stifled and the progress that has been made in the electronification of the fixed income markets will be regressed.
In parallel, trading margins already squeezed by the cost of trade execution on trading venues, are leading some buyside firms to seek to establish bi-lateral connectivity with their sell-side counterparts to reduce these costs. In this scenario, a bank streams prices directly into the OMS and EMS of the buyside firms via APIs. Best execution difficult to evidence, in this case, as multiple prices are required to evidence that the best price was achieved for the client. While ingesting several prices from multiple dealers overcomes that hurdle, it means the bank is potentially crossing the trading venue perimeter and, thus, may require authorisation as a trading venue.
Cost Considerations of Investment-firm & Technology-provider Platforms
ESMA’s definition draws a clear distinction between scenarios where the investment firm owns the trading platform / API and where a technology firm owns it. Firms will need to carefully assess their buy versus build approach when deciding on their order execution workflow, as if the platform is owned by a third-party it may be categorised as a multilateral SDP, which according to ESMA, is a trading venue requiring authorisation.
Technology providers will need to review their business strategy for current and future service offerings, in light of the consultation paper, as failure to do so could be viewed in a negative light by their regulator. Symphony, traditionally an instant messaging platform used by financial services firms, is a recent example.
The firm looked to provide an automated RFQ workflow, through the deployment of a web-based tool SPARC, into their communication platform, allowing market participants to select certain products and parameters to populate and stream RFQs to clients. The tool also incorporated the functionality to allow market participants in receipt of those RFQs to negotiate prices and execute trades. This ultimately led to Symphony being fined by the CFTC for operating a de-facto trading venue without proper authorisation. Although not within the scope of ESMA, the CFTC reached this decision based on similar principles as those of ESMA. Symphony’s communication platform allowed for a genuine interaction of multiple third-party trading interests. This defining feature meant that the system was, in fact, a trading venue, which required authorisation.
ESMA’s current view of the trading venue perimeter may cause sleepless nights for market participants and technology vendors alike, with concerns that it will bring several technology providers into scope unduly and drive-up the cost of trading, which will ultimately be passed on to clients. Firms will, therefore, need to assess their communication platforms, OMS, EMS, RFQ systems and APIs in light of ESMA’s definition.
GreySpark Partners has extensive regulatory change experience, having led several key regulatory change programmes for our clients and a thorough understanding of the technology vendor landscape. We are well placed to help firms who are struggling to identify how ESMA’s view of the trading venue perimeter may impact their current and future trade workflow process.