The new market structure under MiFID II/MiFIR
Set in motion by MiFID in 2007, MiFID II/MiFIR aim at a deeper integration of European financial markets. Increasing competition by creating a level playing field, enhancing efficiency by a defragmentation of markets and improving investor protection by expanding competent authorities’ overall supervisory capabilities are the different streams MiFID II/MiFIR encompass.
In addition to being generally more definite, MiFID II/MiFIR also try to be appreciative of the significant technical progress of the financial industry since the implementation of MiFID I.
In that context, Regulated Markets (RMs) and Multilateral Trading Facilities (MTFs) will be amended by a third category of trading venues. To subject the trading in non-equity instruments currently not conducted via RMs and MTFs to regulation, the so-called Organised Trading Facilities (OTFs) have been introduced. All trading venues will have to comply with new pre- and post-trade transparency obligations and a number of governance and operational stability requirements have been imposed on the different venues.
Where an investment firm deals on own account on an organised, frequent, systematic and substantial basis but outside a trading venue, the firm becomes a Systematic Internaliser (SI). While the concept of SI was introduced by MiFID in 2007, it was then limited to the trading in shares and included no quantitative specification as to its systemic relevance. The substantiality will be calculated by either an investment firm's over-the-counter (OTC) trading volume in a specific instrument vs. its total trading volume in this instrument or, alternatively, by an investment firm’s OTC trading volume in a specific instrument vs. the total trading in the European Union in this instrument.
For derivatives that exhibit sufficient standardisation to be subject to the clearing obligation under EMIR, ESMA shall decide whether such derivatives should be subject to the trading obligation according to MiFIR which entails that financial counterparties will have to trade these instruments via RMs, MTFs, OTFs or equivalent third-country trading venues. Shares admitted to trading/traded on a regulated market will no longer be allowed to be traded on broker-crossing networks. Unless they are either non-systematic, ad-hoc, irregular and infrequent or take place between eligible/professional counterparties and do not contribute to the price discovery process, their trading must be conducted via an RM, MTF, SI or via a third-country trading venue.
Title VI of MiFIR provides rules for the non-discriminatory access to central counterparties (CCPs) and trading venues. The legislative provisions of Art. 35 and Art. of 36 MiFIR include exchange-traded derivatives and take into account that forcing the interconnectedness of systemically important financial market infrastructures in derivatives could potentially pose threats to market integrity and stability, especially in distressed market conditions. Hence, mandatory access may only be granted where it would not threaten the smooth and orderly functioning of markets, in particular due to liquidity fragmentation, would not adversely affect systemic risk and would not require interoperability arrangements.
Where firms from outside the EU (third-country firms) request access, i.e. intend to provide investment services or want to undertake investment activities within the EU, MiFID II/MiFIR differentiate between retail clients on the one hand and professional clients and eligible counterparties on the other hand. According to the Directive, where retail clients are involved, the EU Member State concerned may require the third-country firm to establish a branch within its jurisdiction and to acquire authorisation. This will entail capital and governance requirements and subject the branch to MiFID II/MiFIR provisions. In addition, the Member State will require that there are bilateral agreements on supervisory and tax regimes in place between itself and the third country.
If investment services/activities address or involve professional clients and eligible counterparties, no branch establishment is required if the third-country firm has registered with ESMA, the firm is subject to supervision in its home country and ESMA has in place an equivalence agreement with the respective authority of this country.
The firm needs to inform clients that it is limited to this specific client group and that it is not subject to EU supervision. It must also accept to have legal disputes be settled at a court in a Member State. Where a third-country firm has established a branch in one Member State, there will be a passporting for other Member States within the EU if an equivalence agreement between ESMA and the third-country authority is in place.
Dark pool trading
A – thoroughly deliberate – consequence of the implementation of MiFID I in 2007 was increased competition among trading venues. While pre-trade transparency requirements have existed since, so have exemptions. Four types of waivers have been in place, exempting firms from making their quotes public before the execution of the transaction: the reference price waiver, the negotiated trade waiver, the order management facility waiver and the large-in-scale waiver.
The reference price waiver for MTFs or RMs allows for orders to be matched at the midpoint of the best bid and offer price (with the best bid price being the highest binding bid price available in their order books and the best offer price being the respective binding lowest offer price), effectively granting the tightest spreads.
The negotiated trade waiver can be granted for transactions concluded at or within the current volume-weighted spread reflected on the order book or the quotes of the market makers of the RM or MTF operating the trading system or, where the share is not traded continuously, within a percentage of a suitable reference price, being a percentage and a reference price set in advance by the system operator. The waiver also applies to transactions which are subject to conditions other than the current market price of the equity instrument.
An order management facility waiver may be granted in relation to orders held in an order management facility maintained by the RM or the MTF unless they will be disclosed to the market.
The large-in-scale waiver is available where an order is considered to be “large in scale” compared with normal market size. This is the case if it is equal to or larger than the minimum size of order specified in the Annex to the MiFID II/MiFIR regulatory technical and implementing standards.
While the waivers entailed “dark pools” of large amounts of trading being conducted anonymously, regulators argued that the inconsistent implementation of a waiver regime across venues has weighed on price discovery and transparency.
Double volume cap
Under MiFID II/MiFIR, the percentage of trading in a financial instrument carried out on a trading venue under the negotiated trade waiver and the reference price waiver will be limited to 4 per cent of the total volume of trading in that financial instrument on all trading venues across the EU over the previous twelve months.
At the same time, the overall EU trading in a financial instrument under those waivers may not exceed 8 per cent of the total volume of its trading on all venues throughout the EU over the previous twelve months.
These caps will be measured against a rolling twelve-month period. ESMA is mandated with publishing and updating this data on a monthly basis; prior to this, it has to collate this data from the respective reports filed by the competent authorities which granted the waivers to firms which have to report to ESMA.