Tuesday, May 31, 2011

FSA Senior Official Examines European Commission Proposals to Amend the Markets in Financial Instruments Directive (MiFID)

A senior Financial Services Authority official has examined the European Commission’s proposals to amend the Markets in Financial Instruments Directive (MiFID) and stated the UK position in a number of areas, including high frequency trading, derivatives, and third-party access. In recent remarks, David Lawton, Head of Markets Infrastructure and Policy, said that cross-border investment and market access should be seen as a key enabler for the EU strategy of sustainable and inclusive growth. The MiFID initiative is a serious effort to rethink some major elements of financial regulation, with draft legislation expected this summer.

Access of US and other third-country firms into EU markets is not currently harmonized under MiFID, but instead left to the discretion of Member States subject to the restriction that they do not give third-country firms more favorable treatment than EU firms. The Commission proposes a harmonized regime in MiFID under which third-country investment firms and market operators would be able to access the EU only if their home jurisdictions were assessed to impose equivalent regulation to the EU regime. The access mechanism would initially be applied only for non-retail investors.

The FSA has serious concerns about the introduction of an equivalence mechanism for the access of US and other third- country firms. An equivalence mechanism could significantly reduce the number of third-country investment firms and market operators who currently have access to EU markets, said Mr. Lawton. In addition, determining equivalence jurisdiction by jurisdiction could tie up a significant amount of resources within both the European Securities and Markets Authority and national authorities which would be better deployed focusing on day-to-day regulatory issues.

Also, the establishment of an equivalence mechanism under MiFID could make it more difficult for EU firms and market operators to access US and other third-country markets. Indeed, the FSA believes that efforts to achieve reciprocity on the basis of an equivalence mechanism could damage relations between the EU and other major jurisdictions.

The FSA official said that US and other non-EU firms and market operators should continue to be able to establish investment firms and regulated markets authorized under MiFID by setting up a subsidiary in an EU Member State. At the same time, it should be clarified that Member States should not allow third-country investment firms and market operators to operate in their jurisdiction on a basis which is more favorable than that which applies to MiFID investment firms and that such branches are not entitled to provide services elsewhere in the EU on the basis of a MiFID passport.

The FSA supports the Commission proposal to minimize differing requirements in Member States to improve efficiency when exchanging information with other countries. But Member States and firms should be given sufficient time for implementing the changes and each step towards harmonization must be strongly supported by rigorous cost and benefit analysis.

MiFID currently recognizes three types of organized trading venues: regulated markets, multilateral trading facilities, and systematic internalizers, which are investment firms dealing on their own account on an organized and frequent basis. The Commission proposes that all organized trading occurring outside these venues be brought within a new organized trading facility (OTF). There would be a sub-regime for the trading of standardized derivatives, a Derivatives Trading Venue.

The FSA is concerned that the OTF category will capture forms of trading that are not truly organized or venue-like. A bulletin board, for example, may appear to be like a trading venue, he noted, but a bulletin board is not a system in which trades can be executed or that is governed by a set of trading rules, and should not be caught by venue-like regulation. Moreover, many of the requirements that the Commission indicates might be attached to the OTF category are already requirements under the investment firm regulatory regime, such as the need for appropriate management of conflicts of interest.

Instead, the UK recommends that the Commission retain the current trading venues, but align the organizational requirements for multilateral trading facilities to those of regulated markets in order to address concerns about a level playing field. The FSA supports the creation of a Derivatives Trading Venue in order to deliver on G-20 commitments for the trading of standardized OTC derivatives.

The Commission proposes extending pre- and post-trade transparency requirements to all derivatives and bond markets. On the pre-trade side, market participants on regulated markets , multilateral trading facilities, and the proposed new category of organized trading facilities would be required to quote continuously. For pure OTC trading, quotes would have to be made publicly available when participants were able and willing to quote, and prices would have to be close to the prices of equivalent instruments on an organized venue. On post-trade transparency, market participants would publicly disclose the price and volume of a transaction after it has taken place.

In the FSA’s view, there should be no pre-trade transparency requirements for OTC trading since, in the new regulatory landscape, these markets will by their nature involve sophisticated counterparties trading illiquid and complex instruments. Pre-trade transparency could be seriously disruptive to dealings in these instruments for little benefit.

On the post-trade side, the FSA supports greater transparency for standardized derivatives that are sufficiently liquid, provided that this is delivered in a tailored way which does not damage liquidity. By improving the timely availability of information, reasoned the FSA official, enhanced transparency can improve the price discovery process, make markets more efficient; help investor confidence in the competitiveness of the prices they are quoted, increase liquidity, and aid in the valuation of financial instruments

With regard to best execution, the Commission proposes that execution venues publish data on execution quality in the financial instruments they trade. The FSA believes that execution quality data, published in a standardized form, would facilitate comparisons of execution quality between trading venues. This would help investment firms to select the venues they include in their execution policies and the destination of their orders.

Information that investment firms are likely to be interested in includes price and speed and likelihood of execution. This is the type of information that venues are required to produce in the US under SEC Rule 605, which applies only to trading in shares. The EU should concentrate on execution quality data for liquid shares where there is greatest competition between organized trading venues, noted the FSA official. If the Commission intends to extend the requirement to non-equity instruments, continued the official, it will be important to recognize the differences between different asset classes and conduct a cost benefit analysis with respect to each asset class.

The Commission is proposing to require the authorization of high frequency trading firms above a specified minimum threshold. High frequency trading firms above a certain threshold would also be required to make continuous quotes in the instruments they trade, and platforms would be required to ensure that orders on their markets rest in place for a given period before being cancelled, or, that participants do not submit more than a given ratio of orders to actual trades.

In the view of the FSA, requiring high frequency trading firms that are direct members of a trading venue to be authorized would ensure that these firms are subject to independent regulatory oversight, including transaction reporting requirements if they have non-intermediated, direct access to markets. A ‘cut-down’ set of investment firm requirements should apply to firms that do not have clients.

In addition, MiFID should specify more detailed and robust risk controls that must be put in place by all regulated firms in relation to their automated trading. Such controls must be sufficient for the complexity and volume of the firm’s trading, and must ensure that algorithms are appropriately tested. Similarly, intermediaries that provide sponsored access to automated traders should have thorough controls in place, because activity that takes place under an intermediary’s membership codes is its responsibility. All trading venues should have systems to manage rogue order entry in place, such as appropriate trading suspension mechanisms

The UK does not think a case has been made to mandate the provision of liquidity by high frequency trading firms. Forcing high frequency traders to become market makers may deter them from entering the market altogether, reasoned the FSA, thereby removing the benefits of the liquidity they currently provide voluntarily. It may also create prudential risks for these firms, leaving them exposed to market movements when other participants are at liberty to withdraw.

Similarly, the UK does not believe that the case has been made to require orders to rest on the book for a minimum period of time. Any participant may wish to delete an order quickly for prudential reasons. Forcing participants to remain in the market could damage overall market efficiency and compromise firms’ risk management.

Noting that transaction reporting is a vital tool in maintaining market integrity, the FSA posited that, in principle, the scope of the transaction reporting regime should be aligned with the scope of the Market Abuse Directive. So, for example, if the scope of Market Abuse Directive were to be extended to cover instruments admitted to trading on a multilateral trading facility, then the UK would expect the transaction reporting regime would be set to capture those instruments too. The FSA believes that the existing approach, in which national authorities collect the data, and share it between them as necessary, works well. The additional costs of giving investment firms the possibility of reporting directly to a mechanism at EU level, as the Commission suggests, might largely outweigh the benefits.