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Nick Bayley, Duff & Phelps

A brief history of European market structure


By Nick Bayley (pictured), Duff & Phelps – In the good old days (any time before MiFID came along in 2007) the structure of European capital markets was relatively simple. There were really only two types of markets: highly transparent, exchange-operated markets and relatively opaque, over the counter (OTC) markets.  

This was an era when the European markets were almost entirely free of statutory regulation and the exchanges were de facto monopolies in their particular asset class and jurisdiction.  In order to trade equity, equity derivatives, commodity futures or whatever, you had to be a member of the relevant exchange and you contractually agreed to abide by the rules of that exchange. 

For equity trading for example, the LSE was the only show in town – it wrote the rules and it decided on the level of transparency of both electronic on-order book and bilateral off-book trading. OTC trading took place in equities, but only went on between non-members of the exchange. 

For other markets – such as those in fixed income securities, interest rate swaps and FX derivatives – trading was conducted OTC and transparency was very limited. 

For equities, this all changed when the Markets in Financial Instruments Directive (MiFID I) was introduced in Autumn 2007, becoming a cornerstone of European financial markets regulation.  MiFID I not only ended the monopoly enjoyed by European equity exchanges but introduced comprehensive statutory, governmental regulation of markets for the first time, in place of the self-regulation that had existed for a couple of centuries. 

New trading platforms competing with the established exchanges sprang up. These venues, known as multilateral trading facilities or MTFs were effectively mini-exchanges that broadened the market ecosystem.  The MTFs, most of which only run a secondary market in financial instruments listed elsewhere, operate using various models.  Some use electronic order books, similar to the LSE’s SETS order book, whilst others act as a venue for the reporting of off-book trades.  

At the same time MTFs also sprung up in asset classes other than equity – although MiFID I did not prescribe any particular detailed transparency arrangements for these non-equity instruments, something that is changing now with MiFID II.  

MTFs, in common with exchanges, operate on a non-discretionary basis, which means that the platform operator sets up a series of rules, typically coded within an electronic system and then lets that system operate unimpeded.  An MTF operator cannot interfere with the flow of trades taking place between its participants, except in extremis, in order to protect the orderliness of its markets.   

So, under MiFID I two breeds of trading venues were available: regulated markets (operated by exchanges) and MTFs (operated either by exchanges or authorised firms), with the OTC markets still ticking along in the background.

Under MiFID II, the second iteration of the Markets in Financial Instruments Directive, a third type of trading venue will be introduced to the market; namely the Organised Trading Facility or OTF.  This is a slightly different beast from an MTF.  

The OTF regime is designed for multi-lateral trading in non-equity, such as fixed income and derivative instruments.  If you want to provide a multilateral platform for equity trading, that must be an MTF.  However, non-equity can also be traded multilaterally on an MTF.  So far, so clear as mud. 

So, what differentiates an OTF from an MTF?  

The MiFID II OTF regime has been designed to accommodate trading models in which the broker who runs the trading venue can and does apply discretion in relation to how it handles orders and executions under its auspices.  A detailed discussion on what does and doesn’t constitute discretion is not blog material but ESMA has produced some detailed Q&A on this topic for those of you that are interested.     

The key point is that the OTF regime allows for, and specifically accommodates, a conventional brokerage model where a broker takes an order and goes out to several market participants looking for the other side of the trade.   Whether a broker, particularly if it is a pure voice-broker, is obliged to become an OTF continues to be matter of some debate.  Being a trading venue is quite a big deal.  It will cost a lot of money simply applying to become one and it substantially elevates a firm’s regulatory status and also the level of scrutiny a firm can expect from the regulators. 

From January 2018, European market structure will be split into four camps: regulated markets, MTFs, OTFs – collectively referred to as trading venues - and OTC. 

Within the OTC space, a participant can also trade with firms that may be acting as what is known as a Systematic Internaliser (‘SI’).  This is defined as a firm that “on an organised, frequent systematic and substantial basis, deals on own account when executing client orders outside a regulated market, an MTF or an OTF without operating a multilateral system”.  An SI is not a trading venue.  If a firm undertakes the above activity in excess of a certain level in an instrument, then it must be an SI and then has certain quoting obligations. These are complicated and depend on the instrument, the asset class, the instrument’s liquidity and so on.  Perhaps confusingly, it is also possible to opt to be an SI even if you don’t meet the prescribed thresholds.

There are many questions about how the SI regime will operate in practice under MiFID II. One of the things that the European Commission is nervous about is that SIs or electronic networks of SIs could operate in manner that takes liquidity away from the more heavily regulated and transparent trading venues.

However, taking a step back from all of this, in terms of how market structure will evolve, I expect that after a period of some confusion (but hopefully not chaos) in early 2018, we will see OTC trading gravitating towards more liquid and transparent venues.   

Broker-dealers will be operating OTFs in a number of different asset classes with some trading models being fully electronic order books, some ‘request for quote’, some voice/electronic hybrid.  We will have to wait to see how well these venues retain their existing business and attract new liquidity.  What history has shown us is that once markets become sufficiently transparent, the available liquidity tends to become concentrated in particular venues at the expense of others.

Better pre- and post-trade information after January 2018 will inform the whole market of those trading venues where liquidity can be found.  People will quickly work out where best execution can be consistently be obtained and will concentrate their flow into those places.   

Under MiFID II, firms trading in those asset classes which are not currently very transparent will, quite rightly, question whether they are still trading with the right counterparties and in the right venues.  

There are many markets that are ripe for reform, such as the one in UK Gilts, which currently operates in a manner which lacks transparency and uses outdated trading mechanisms. There will inevitably be a shake-up of many established trading relationships but in the long run, spreads should tighten, costs should reduce and investors will get a better deal.

For buy-side firms, I expect it will largely be business as usual in January for trading in equities.  But for non-equity the increased transparency from day one will change things and will lead to upheaval in those markets as trading moves to where the liquidity is. 

I have been doing this regulation stuff a long time and MiFID II is far and away the most complicated and detailed piece of regulation any of us have seen.  It will change the face of European market structure, almost certainly for the better, but also possibly in other ways we cannot fully predict. 

 


Nick Bayley is a managing director in the Compliance and Regulatory Consulting practice at Duff & Phelps. Prior to this, Nick was a Head of Department in the FCA's Markets Policy & International Division, FCA Senior Markets Adviser and was responsible for the UK regulator’s MiFID II Policy Project. 

 

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