Systematic Internalisers: closing the loopholes
Since the introduction of the original MiFID Directive, the European legislator has distinguished between several types of “execution venues”: regulated markets and multilateral trading facilities on the one hand (jointly referred to as “trading venues”), subject to broadly similar rules, and “systematic internalisers”(SI) and other “over-the-counter” (OTC) trading on the other hand. Article 23 of MiFIR now contains a “trading obligation “for equity instruments: all investment firms must now execute shares (that are traded on a trading venue) on a regulated market, MTF or SI, unless the trades are ad-hoc, non-systematic, irregular or infrequent (or are between professional counterparties and do not contribute to the price discovery process). This trading obligation was meant to curtail the trading via “broker-crossing networks”, but has created in the minds of some market participants the impression that SIs are somehow “elevated” to the same level as trading venues. Since SIs are subject to less stringent requirements than trading venues, the excitement of banks to seize this opportunity has been palpable. In fact, the market share of SIs has increased exponentially: from approximately 1% in January 2017 to 15% in January 2018. SIs are now the dominant force on certain markets: 40% of trading in the BEL-20 index is handled by SIs!
Systematic Internalisers are a specific type of execution venue: trades are not executed on a “neutral platform” where buy and sell interests are aggregated, but against the SI’s (i.e. a bank’s) own book, on a bilateral basis. The SI makes money by capturing the spread (difference between buy and sell prices) and risking its own capital. The legislator has always had a tough balancing act with regard to SIs: acknowledging that they do, in certain circumstances, enhance liquidity (and thus should be allowed to function), while being concerned about the lower transparency and conflicts of interest (and thus should not be promoted to the point that trading is transferred from multilateral venues to SIs).
A simple solution would have been to allow SIs to operate only where they clearly add liquidity – e.g. for trades which are clearly bigger than “standard market size” and/or for illiquid shares – and ensure that trades up to standard market size are always executed on multilateral trading venues (where the same SIs could act as market maker). Under pressure from banks, the European legislator has opted for a more complicated mechanism, whereby SIs can act in all sizes, but are obligated to behave “more or less” like multilateral venues if they trade up to standard market size. It is the definition of this “more or less” that has proven to be extremely difficult in the past years and with which the Commission and ESMA are still struggling today.
MiFIR sets out the principles in article 14.3: SIs may quote in any size they like (with a minimum quote size equal to 10% of the standard market size). They must publish “firm quotes” up to standard market size (i.e. quotes which can be executed by the firm’s customers). These quotes should reflect prevailing market conditions. This vague concept was not really further defined in the Regulatory Technical Standards: article 10 of RTS 1 (Commission Delegated Regulation 2017/587), merely states that prices reflect prevailing market conditions when they are “close in price” to the prices quoted on the most relevant market for that instrument. Defining a vague term by using an equally vague notion leaves the gate wide open for SIs to use the margin of interpretation as a competitive advantage against multilateral trading venues and thus force trading from multilateral to bilateral platforms. In fact, the number of SIs has risen rapidly in preparation of the launch of MiFID II. One of the potential regulatory arbitrage opportunities for SIs would be to use a different “tick size” than the minimum tick sizes that apply to the multilateral markets. For instance, if Euronext quotes 83.91-83.92 for a liquid instrument like AB Inbev, an SI can offer a “better price” (and potentially ensure higher flows of trading to itself pursuant to the best execution obligation of investment firms) by quoting 83.911 and 83.919, a price which is “close”enough to satisfy the requirement of article 10 RTS 1. Multilateral venues are not able to compete with this price, since they are subject to the “minimum tick size”regime of RTS 11 (which only applies to “trading venues”) which states that even the most liquid instruments with a share price of more than 50 have a minimum tick size of no more than two decimal points. This regime was introduced to create a level playing field and avoid a further race to the bottom in tick sizes, which is deemed to have a negative effect on market depth and the quality of liquidity.
The Commission and ESMA have belatedly realised the problem and are trying to remedy it, by changing article 10 of RTS 1 to state that SIs must trade at the same tick sizes as the trading venues “where the price levels could be traded on a trading venue at the time of publication”. The convoluted proposed wording means that the requirement only applies when the same price levels are available on the trading venue, while the appropriate remedy would have been an amendment to RTS 11 to extend the tick size regime completely to SIs. ESMA has published a Consultation Paper on 9 November 2017 and the responses have now been made available: most respondents are in favour of the change. ESMA has already tried to prevent other regulatory arbitrage opportunities through its Q&A on market structure topics by clarifying that SIs are prohibited from operating any system that would bring together third party buying and selling interest (e.g. by linking up various SIs, using an internal matching engine, ensuring that they “de facto” have no risk through back-to-back transactions, etc), although in reality the difference between an SI entering into hedging transactions to cover risk and an SI seeking to circumvent regulation by offloading the risk to a third party, may be difficult to establish. ESMA also clarified that SIs must publish transactions as “close to real time as possible”. The remediation of deficiencies in Level 1, and especially Level 2, legislation through Q&A guidance is certainly not the most elegant solution.
While it now looks like the Commission will be able to close the tick size issue through a direct change of Level 2 regulations, there are a number of loopholes which remain open to SIs and, until the Commission makes clear choices, the popularity of the SIs will increase to the detriment of multilateral trading venues, which have higher (regulatory) costs and burdens. For instance, an SI is still able to offer “price improvement” to specific clients in “justified cases”: i.e. execute orders at better prices than those publicly quoted. While ESMA has made clear that SIs must abide by the minimum tick size in this case as well, the price improvement possibility still offers a competitive advantage to SIs over trading venues which do not have the same latitude (although the waivers relating to reference price trades, large in scale trades and negotiated trades, do leave some room). Also, while a trading venue must give non-discriminatory access to market participants, SIs do not have such an obligation, leaving room for trading models which cater to a very specific subset of customers that reduce the risk to the SI (i.e. by trading only with “unsophisticated flow”).
This difference in treatment is difficult to reconcile with the stated objective of MiFID 2 to make financial markets more transparent and efficient and to level the playing field between various venues. The patchwork approach to closing the loopholes is not likely to solve this structural issue and is likely to lead to legal insecurity for market participants. A more thorough revision of the Level 1 and 2 texts is needed.