Page 1 of 4
- on 29 May 2018 - clearence on whether an OTF can arrange or trade strategies including an equity leg,
- on 3 October 2017 - clearance on the OTF and the REMIT carve-out interrelations.
|
OTF are regulated in the provisions of Title II of the MiFID II Directive, thus operating an OTF is classified as an investment service.
As a consequence, only persons licensed as an investment firm under MiFID are entitled to run an OTF (operation of an OTF is included in the Section A (investment services and activities) of the MiFID II Annex I point 9).
The creation of the OTF category was expected to bring systemic benefits, in particular aid the price formation process in bonds and derivatives as well as enhance the resilience of the systems being used for the trading of these instruments.
The conception for OTF is broad and includes a multitude of electronic platforms that were not so far subject to requirements applied to regulated markets and MTFs, for this reason an OTF is often perceived as a catch-all category of a trading venue.
However, it needs to be noted that "recital 8 of MiFIR clarifies that an OTF should not include facilities where there is no genuine interaction of trading interest, such as bulletin boards used for advertising buying and selling interests, other entities aggregating or pooling potential buying or selling interests, electronic post‑trade confirmation services, or portfolio compression. Any system that only receives, pools, aggregates and broadcasts indications of interest, bids and offers or prices shall not be considered a multilateral system for the purpose of MiFID II. This is because there is no reaction of one trading interest to another other within these systems – they do not 'act reciprocally'" (Financial Conduct Authority, Markets in Financial Instruments Directive II Implementation – Consultation Paper I, December 2015, CP15/43, p. 49).
|
An entity should seek authorisation to operate an OTF where the three following conditions are met
|
 Trading is conducted on a multilateral basis
Interaction with a view to trading in a financial instrument is conducted in such a way that a trading interest in the system can potentially interact with other opposite trading interests.
As OTFs are required to “have at least three materially active members or users, each having the opportunity to interact with all the others in respect to price formation” (Article18(7) of MiFID II), an OTF user’s trading interests can potentially interact with those of at least two other users.
On OTFs, the interaction of user trading interest can take place in different ways, including through matched-principal trading or market-making, within the limits set out in Article 20(2) and 20(5).
The trading arrangements in place have the characteristics of a system
MiFIDII/MiFIR is technology neutral and accommodates a variety of “systems”.
A system would be easily identified when embedded in an automated system.
This would cover a situation where, for instance, the arrangements in place consist of the automated crossing of client trading interests, subject to the exercise of discretion on an OTF.
However, other non-automated systems or repeatable arrangements that achieve a similar outcome as a computerised system, including for instance where a firm would reach out to other clients to find a potential match when receiving an initial buying or selling interest, would also be characterised as a system.
Where a firm would, by coincidence and accidentally, receive matching buying and selling interests, and decide to execute those orders internally, such unpredictable circumstances would not qualify as the operation of a system.
The execution of the transaction is taking place on the system or under the rules of the system
The execution of the orders would be considered to be taking place under the rules of the system including where, once the trade price, volume and terms have been agreed through a firm, the counterparties’ names are disclosed, the firm steps away from the transaction and the transaction is then legally formalised between the counterparties outside a trading venue.
If an investment firm arranges a transaction between two clients and the clients decide to formalise the trade on a regulated market or an MTF, the transaction would not be considered as taking place under the rules of the system because a transaction cannot be concluded on more than one venue.
If an investment firm were to arrange transactions on one system and provide for the execution of the transactions on another system for avoidance purposes, the disconnection between arranging and executing would not waive the obligation for the investment firm operating those systems to seek authorisation as an OTF operator.
|
| |
Voice trading systems
UK HM Treasure in the MiFID II Consultation Impact Assessment (p. 3) said:
"MiFID II adds one new investment service and activity: operation of an Organised Trading Facility (OTF). An OTF is the platform for multilateral trading interests to interact leading to transactions in the financial instrument. However, in contrast to an MTF where the operator of the platform plays a neutral role in bringing about transactions, the operator of OTF plays an active role in bringing together buying and selling counterparties and helping them to negotiate the terms of a trade. This will often involve voice trading where the operator contacts counterparties by telephone or electronic communications to develop a transaction."
Also ESMA underlined that MiFID II is technology neutral and the OTF definition includes voice trading in the same way as the definition of regulated markets and MTFs include voice trading systems.
Therefore, an investment firm executing transactions through voice negotiation would be considered as falling under the definition of an OTF where the arrangements in place would meet the aforementioned general conditions.
Regulated markets and MTFs vs. OTFs - comparison
A common feature of all trading venues, namely regulated markets, MTFs, and OTFs, is the requirement to lay down transparent and non discriminatory rules governing access to the facility.
However, while regulated markets and MTFs are subject to similar requirements regarding whom they may admit as members or participants, OTFs are able to determine and restrict access based inter alia on the role and obligations which they have in relation to their clients.
In this regard, OTF may specify parameters governing the system such as minimum latency provided this is done in an open and transparent manner and does not involve discrimination by the platform operator.
OTF-relevant financial instruments
1. bonds
2. structured finance products
3. emissions allowances
4. derivatives
OTFs follow similar organisational requirements to MTFs, however, OTFs have a number of a distinct features:
- OTFs may only trade in bonds, structured finance products, derivatives and emission allowance (non-equity instruments);
- there are less stringent limitations to the type of activities that the operator of the OTF may undertake both in relation to matched principal trading and trading on own account (additional restrictions apply as an OTF and a systematic internaliser (SI) cannot be operated by the same legal entity);
- as opposed to regulated markets and MTFs governed by non-discretionary rules, the OTF operator must must play an active role in bringing about transactions on its platform and exercise discretion either when deciding to place or retract an order on the OTF and/or when deciding not to match potential matching orders available in the system;
- as opposed to regulated markets and MTFs that have members or participants, OTFs have clients (as a consequence, transactions concluded on OTFs have to comply with client facing rules, including best execution rules, regardless whether the OTF is operated by an investment firms or a market operator); and
- wholesale energy products that must be physically settled do not qualify as financial instruments when traded on an OTF (so-called "REMIT carve-out" - see below).
Discretionary order execution
While regulated markets and MTFs have non-discretionary rules for the execution of transactions, the operator of an OTF carries out order execution on a discretionary basis subject, where applicable, to the pre-transparency requirements and best execution obligations (this is without prejudice to the fact that, because an OTF constitutes a "genuine trading platform", the platform operator should be neutral - Recital 9 MiFIR).
Discretionary order execution is potentially the most vague and ambiguous element of the OTF's regulatory set-up.
Intuitively, the application of discretion may be particularly interesting if put against the background of the neutrality, the OTF is required to preserve.
Pursuant to MiFIR the market operator or investment firm operating an OTF are required to "make clear to users of the venue how they will exercise discretion."
Execution on a discretionary basis means that the OTF's operator:
- has options to consider for the execution of a client’s order, and
- exercises a judgement as to the decision to make and the way forward.
An investment firm or market operator operating an OTF can only exercise discretion in the following circumstances (Article 20(6) of MiFID II):
(a) when deciding to place or retract an order on the OTF they operate;
(b) when deciding not to match a specific client order with other orders available in the systems at a given time, provided it is in compliance with specific instructions received from a client and with its obligations in accordance with Article 27 of the MiFID II (obligation to execute orders on terms most favourable to the client).
The discretion must be exercised at either or both of the above levels (the aforementioned FCA Consultation Paper I of December 2015, CP15/43, p. 114).
For the system that crosses clients' orders the OTF operator may decide if, when and how much of two or more orders it wants to match within the system.
The OTF operator may facilitate negotiation between clients as to bring together two or more potentially compatible trading interests in a transaction.
ESMA has issued an extensive guidance on what is meant by the discretionary order execution by the OTFs - see Questions and Answers on MiFID II and MiFIR market structures topics, 5 April 2017, ESMA70-872942901-38.
Firstly, ESMA has explained that the exercise of any form of discretion does not automatically mean that a venue is an OTF.
Further, referring to the aforementioned MiFID II Article 20(6), ESMA analysed in greater detail what is covered by the exercise of discretion at each of the respective levels: a) order discretion and b) execution discretion.
|
Exercise of discretion by the OTF at order level
|
When an investment firm or a market operator receives an order from a client, the “order discretion” refers to the judgement exercised by the OTF operator whether to place the order at all on the OTF, whether to place the whole order or just a portion of it on the OTF, and when to do so.
When an investment firm or a market operator receives an order from a client, the “order discretion” refers to the judgement exercised by the OTF operator whether to place the order at all on the OTF, whether to place the whole order or just a portion of it on the OTF, and when to do so.
This may be the case for instance where an investment firm would receive a buy order for a 500 lots and would decide to place an order for 200 lots only on the OTF, the remaining 300 lots being executed elsewhere.
Similarly, and as opposed to the operator of an MTF which may not withdraw an order from the MTF at its own initiative unless for fair and orderly market purposes, the operator of the OTF is expected to make a judgement as to whether and when an order should be retracted from the OTF.
This may be the case where, at a given point of time, the OTF operator considers that a more favourable outcome would be obtained by executing the order on another execution venue foreseen in the best execution policy.
The OTF operator may also have placed the order on the OTF, sent it to another trading venue simultaneously, subsequently decided to have the order executed on the trading venue and retracted it from the OTF.
The exercise of order discretion would always have to comply with the OTF best execution policy and with client order handling rules.
Where clients would be providing a specific instruction to the operator of the OTF, the OTF operator would not be considered as exercising order discretion when complying with that specific instruction.
|
|
Exercise of discretion by the OTF at execution level
|
Under MiFID II Article 20(6), the exercise of discretion at execution level has to be in compliance with client specific instructions and the best execution policy.
The mere implementation of client specific instructions or of best execution obligations would not be the exercise of discretion.
The operator of the OTF is expected to exercise a judgement as to if, when, and how much of two matching orders in the system should be matched.
For instance, assuming a buy side order for 500 bonds and an opposite order of 200 bonds have been placed into the OTF, the operator of the OTF would exercise discretion when deciding whether the 500 buy side order should not be matched with the sell side order.
The exercise of discretion, be it “order discretion” or “execution discretion”, should not be just a possibility foreseen in the rules of the OTF and in the best execution policy of the OTF operator.
Discretion has to be actually implemented by the operator of the OTF as part of its ordinary course of business and should be a key part of its activities. It is not expected that any quantitative threshold would be set to assess the exercise of discretion.
However, as provided for under Article 20(7) of MiFID II, at the time of authorisation or on ad-hoc basis, the market operator or the investment firm operating an OTF should be able to provide to its national competent authority a detailed description of how discretion will be exercised and in particular when an order may be retracted from the OTF and when and how two or more client orders will be matched in the OTF.
The OTF operator should be able to explain to its national competent authority the rationale underpinning the exercise of discretion, such as the set of reasons and the logical basis for not matching two opposite buying and selling interests.
Random placing, retracting, matching or non-matching of orders on the OTF would not be considered as the exercise of discretion.
Likewise, the exercise of pre-trade controls by the operator of the OTF to ensure fair and orderly trading would not qualify as the exercise of discretion.
Post-trade decisions, for example over where transactions are settled, are not relevant either for the purposes of these provisions.
Similarly, the decision to enter into a client relationship in compliance with OTF rules on non-discriminatory access does not constitute discretion under Article 20(6) of MiFID II.
|
With respect to exercise of discretion by the OTF a number of specific issues arose.
Among them was whether a discretion have to be exercised on an order by order basis.
ESMA with this respect also differentiated legal circumstances at an order level and at a transaction level.
Discretion at order level does not have to be exercised by the OTF order by order.
As an example, the OTF operator may consider, at a given point in time that some or all orders of a specific size in a specific instrument should be retracted from the OTF as more favourable conditions are temporarily available elsewhere.
However, the OTF operator must have the ability to exercise discretion at order level if circumstances so require, for instance in case of prior execution of an order on another trading venue.
Conversely, at execution level, discretion whether not to match two potential matching buying and selling interests can only be meaningfully exercised by the OTF at order level.
Another problem was whether the use of a fully automated system excludes the exercise of discretion and should therefore be automatically classified as an MTF.
ESMA answered to this question in the negative.
MiFID II is ‘technology neutral’ and permits any trading protocol to be operated by an OTF, provided it is consistent with fair and orderly trading and the exercise of discretion.
Tthe exercise of discretion as to if and when to place or retract an order could possibly be automated through artificial intelligence and algorithms, without necessarily the exercise of human judgement on a case by case basis.
Conversely, human intervention is not necessarily sufficient to prove the exercise of discretion.
Human intervention that is not based on the exercise of human judgement (for instance, only consisting in the random placing or retracting or matching/non-matching of orders) would not be considered as the exercise of discretion.
When discretion is exercised at execution level, i.e. when deciding if, when or how much of two or more trading interests should (or should not) be matched, the exercise of discretion would not preclude the use of automated systems, provided that certain conditions are met.
In particular, the sophisticated algorithms supporting automated matching would need to anticipate the circumstances under which the orders would not be matched; they would also have the capacity to ensure that the decision to match (or not to match) two opposite trading interests is in compliance with the best execution policy or a client specific instruction.
As one of the differentiating factors from execution algorithms operated by MTFs, the algorithms operated by the OTF would be expected to take into account external market factors or other external source of information to demonstrate the exercise of discretion.
Regulatory regime for OTF
MiFID II supplemented Annex I Section A of MiFID I (containing the list of investment services and activities) with point 10 which reads: "Operation of Organised Trading Facilities".
Hence, there should be no ambiguities that the operation of an OTF represents an investment service in the MiFID II meaning and, consequently, requires an investment firm licence.
The following effect is that market operator authorised to operate an OTF must ensure compliance with the provisions in Chapter 1 of the MiFID II regarding Conditions and Procedures for Authorisation for Investment Firms.
Hence, contrary to MTF, the following articles of the MiFID II Directive are applicable to the transactions concluded on an OTF:
- 24 (general principles and information to clients),
- 25 (assessment of suitability and appropriateness and reporting to clients),
- 27 (obligation to execute orders on terms most favourable to the client), and
- 28 (client order handling rules).
Moreover, a relevant operator operating an OTF must provide its competent authority the rules and procedures to ensure compliance with the said Articles 24, 25, 27 and 28 of MiFID II for transactions concluded on the OTF where those rules are applicable to the relevant operator in relation to an OTF user (Article 6(e) of the Commission Implementing Regulation (EU) 2016/824 of 25 May 2016 laying down implementing technical standards with regard to the content and format of the description of the functioning of multilateral trading facilities and organised trading facilities and the notification to the European Securities and Markets Authority according to Directive 2014/65/EU of the European Parliament and of the Council on markets in financial instruments).
The novelty in the design of the OTF as the regulated entity was presumably at the origin of the rule stipulating that the competent authority may require, either when an investment firm or market operator requests to be authorised for the operation of an OTF or on ad-hoc basis, a detailed explanation why the system does not correspond to and cannot operate as a regulated market, MTF, or systematic internaliser and a detailed description as to how discretion will be exercised, in particular when an order to the OTF may be retracted and when and how two or more client orders will be matched within the OTF.
In addition, the investment firm or market operator of an OTF is obliged to provide the national competent authority with information explaining its use of matched principal trading.
Moreover, pursuant to Article 2(2)(d) of the said Commission Implementing Regulation (EU) 2016/824 of 25 May 2016, a relevant operator has an obligation to provide its national competent authority with a detailed description of the functioning of its trading system specifying, among others, "a description explaining how the trading system satisfies each element of the definition of an OTF."
Further, market operator is required to provide information on:
- whether the system represents a voice, electronic or hybrid functionality;
- in the case of an electronic or hybrid trading system, the nature of any algorithm or program used to determine the matching and execution of trading interests;
- in the case of a voice trading system, the rules and protocols used to determine the matching and execution of trading interests (Article 2(2)(a) - (c) of the said Commission Implementing Regulation 2016/824 of 25 May 2016).
Transparent and non-discriminatory OTFs' access rules
Article 18(3) of MiFID II requires that investment firms and market operators operating an OTF establish, publish and maintain and implement transparent and non-discriminatory rules, based on objective criteria, governing access to its facility.
The brief overview of the non-exhaustive list of arrangements which are considered non-objective and discriminatory has been given by the EU financial market watchdog in the Questions and Answers on MiFID II and MiFIR market structures topics of 7 July 2017 (ESMA70-872942901-38).
In the document ESMA said:
a) OTFs should not require members or participants to be direct clearing members of a CCP.
Given the protections afforded to non-clearing members under MiFIR and EMIR, as well as the rules on straight through processing (STP), an OTF should not require all its members or participants to be direct clearing members of a CCP.
OTFs may however require members or participants to enter into, and maintain, an agreement with a clearing member as a condition for access when trading is centrally cleared.
b) For financial instruments that are centrally cleared, OTFs should not allow members or participants to require other members or participants to be enabled before they are allowed to trade with each other.
There are legitimate checks that a OTF might carry out before allowing a member or participant on to their venue.
For example, in markets for non-centrally cleared financial instruments OTFs may wish to carry out credit checks, or ensure that a member or participant has appropriate capital to support the positions it intends to take on the OTF.
In a non-centrally cleared derivatives market, there may be a need for bilateral master netting agreements to be in place between participants before the OTF can allow their trading interests to interact.
OTFs will also need to be comfortable that potential participants are meeting the regulatory requirements to be a member of an OTF such as having appropriate systems and controls to ensure fair and orderly trading.
However, in centrally cleared markets, enablement mechanisms whereby existing members or participants of an OTF can decide whether their trading interests may interact with a new participant’s trading interest are considered discriminatory and an attempt to limit competition.
Enablement mechanisms also reduce the transparency around the liquidity available on different trading venues.
c) OTFs should not require minimum trading activity.
OTFs should not require minimum trading activity to become a member or participant of a trading venue, as this could restrict the access to the OTFs to large members or participants.
d) OTFs should not impose restrictions on the number of participants that a participant can interact with.
In a request for quote (RFQ) protocol, a OTF should not impose limits on the number of participants that a firm can request a quote from.
Whilst a firm requesting a quote may, in compliance with Article 28 of MiFID II, want to limit the number of participants it requests quotes from in order to minimise the risk of unduly exposing its trading interest, which could result in it obtaining a worse price, this should not be mandated by the OTF.
For instance, where a smaller firm is requesting a quote to execute a low volume trade, it might be less concerned about the risks of exposing its trading interest, and so happier to request quotes from a larger number of market makers or liquidity providers.
Limiting the number of participants a firm can request quotes from risks restricting the ability of market participants to access liquidity pools, and only sending requests to traditionally larger dealers who they assume might have larger inventories.
This simultaneously restricts the ability of the requestor to access the best pool of liquidity and reduces the likelihood of a smaller dealer receiving requests, despite it having a strong trading interest.
Application of the best execution policy in an OTF
ESMA has explained that where an investment firm operates an OTF, the investment firm’s best execution should cover how orders are executed both at the level of the investment firm and at the level of the OTF and, in particular, how discretion is exercised at each stage.
Firstly, an investment firm operating an OTF should, in the same way as other investment firms that execute client orders, have a firm-level execution policy setting out the various execution venues, including its own OTF, that it will be considering when receiving a client order and explain in which circumstances an execution venue would prevail over the others.
Secondly, the investment firm should have either a separate policy or an additional section in the firm-level execution policy governing how, when a client order is sent to the OTF, the best possible result for the client is achieved taking into account the trading interests in the system and the different execution mechanisms that may be available on the OTF, such as voice execution, electronic RFQ or order book.
As the exercise of discretion by the investment firm in its OTF operator capacity is to be in compliance with its execution policy, the document should also set out in details the area(s) in which the OTF operator intends to exercise discretion and the basis on which such discretion will be exercised (Article 20(6) of MiFID II).
Equivalent requirements apply to a market operator operating an OTF.
In this regard, a market operator would need to have a best execution policy in place, setting out the conditions under which an order received by a client may be executed on its OTF, as described above (Questions and Answers on MiFID II and MiFIR investor protection and intermediaries topics, ESMA35-43-349, Question 13 updated on 4 April 2017).
Moreover, in the Answer to Question 19 in the Questions and Answers on MiFID II and MiFIR market structures topics, ESMA70-872942901-38 ESMA clarified on 3 October 2017 the issue how the OTF best execution obligations apply when third-party brokers are clients of the OTF or when these brokers provide Direct Electronic Access (DEA) (Article 4(1)(41) of MiFID II).
According to ESMA, when an investment firm or a market operator operating an OTF receives orders or indications of interest from a broker acting on behalf of its own clients, the operator of the OTF should be implementing its own best execution policy when executing the order from the broker orders as it owes its user clients (the broker) the duty of best execution.
The broker should determine that the OTF it selects allows it to comply with its best execution obligations towards its own clients.
To that end, the broker should conduct a performance assessment of the OTF including how discretion is exercised.
In the specific case of DEA to an OTF, the DEA order is entered in the OTF client’s name (the broker) and the OTF operator should execute the DEA order as it would for any OTF client order.
Alternatively, the operator of the OTF may decide not to permit DEA to its system.
ESMA also noted that a DEA order could be considered as a client specific instruction to the broker providing the DEA arrangement to its clients.
OTF and systematic internaliser interrelations
The operation of an OTF and systematic internalisation within the same legal entity is not allowed under MiFID II.
Systematic internaliser (SI) and an OTF mustn't be operated by the same legal entity even when they do not trade the same instruments or class of instruments (e.g. an SI in equities and an OTF in derivatives).
Article 20(4) MiFID II
Member States shall not allow the operation of an OTF and of a systematic internaliser to take place within the same legal entity. An OTF shall not connect with a systematic internaliser in a way which enables orders in an OTF and orders or quotes in asystematic internaliser to interact. An OTF shall not connect with another OTF in a way which enables orders in different OTFs to interact.
ESMA on 3 April 2017 expressed the view that the very general wording of Article 20(4) of MiFID II introduces a blanket prohibition of the combination of the OTF and SI activities by the same legal entity across asset classes and instruments.
On the ground of the above rule the ambiguity, moreover, arouse whether shared resources between separate entities are legally possible, where an investment firm that is an SI set up a separate legal entity to operate an OTF (or vice-versa).
According to ESMA, having two separate legal entities operating the OTF and the SI aims at ensuring that each venue is operated to the sole benefit of its respective clients and is not influenced in any way by the activity undertaken by the other venue.
To that end, ESMA is of the view that the two legal entities respectively operating the SI and the OTF should have arrangements in place that prevent information sharing on each other’s relevant activities regarding the operation of the OTF and the SI.
The OTF operator or any entity that is part of the same group or legal person as the investment firm or market operator should not act as systematic internaliser in the OTF operated by it (MiFIR Recital 9).
This would include for instance having distinct management and operational teams and physical separation of activities.
Similarly, whereas some elements of the IT infrastructure could be shared, execution systems would be expected to be segregated and safeguards in place to ensure that there is no information leakage across the SI and the OTF activities.
Outsourcing from one legal entity to the other should only be considered where the arrangements in place meet a similar test.
The above is without prejudice to the MiFID II provisions on identification and management of conflicts of interest to be met by each of the two investment firms.
Another aspect is that Article 20(4) of MiFID II limits the circumstances under which an OTF may connect with other liquidity pools by prohibiting orders placed in an OTF to interact with quotes or orders in a SI or with orders in other OTFs.
According to ESMA (Q&As of 03.04.2017), interaction would occur when buying and selling interests would comingle in the same liquidity pool.
Accordingly, an SI quote may not be placed on an OTF. Nor can an order originating from another OTF.
ESMA highlights that a trading interest in an OTF may not be executed against an opposite order or quote on another execution venue.
For a transaction to take place, the two opposite trading interests must be placed with the same execution venue.
However, this does not prevent the investment firm or the market operator operating an OTF from retracting the order from the OTF and sending it to another OTF, to an SI, an MTF or a regulated market, where consistent with the investment firm’s or the market operator’s execution policy and exercise of discretion.
Execution of client orders in an OTF against the proprietary capital of the investment firm or a market operator
Investment firm or a market operator operating an OTF is not granted the possibility to execute client orders in an OTF against the proprietary capital of the investment firm or market operator operating the OTF or from any entity that is part of the same corporate group and/or legal person as the investment firm and/or market operator.
Investment firm or market operator operating an OTF is, however, allowed to engage in matched principal trading in bonds, structured finance products, emission allowances and certain derivatives (which ones presumably be specified by Member States implementing the Directive) provided the following conditions are met:
1. the above financial instruments are not subject to the clearing obligation under EMIR,
2. the client has consented to the process.
Investment firm or market operator operating an OTF is also allowed to engage in dealing on own account other than matched principal trading with regard to sovereign debt instruments, for which there is not a liquid market.
Article 20(3) MiFID II
Member States shall permit an investment firm or market operator operating an OTF to engage in dealing on own account other than matched principal trading only with regard to sovereign debt instruments for which there is not a liquid market.
Liquidity for the purposes of this provision should be assessed using the criteria stipulated in the Commission Delegated Regulation (EU) 2017/583 of 14 July 2016 supplementing Regulation (EU) No 600/2014 of the European Parliament and of the Council on markets in financial instruments with regard to regulatory technical standards on transparency requirements for trading venues and investment firms in respect of bonds, structured finance products, emission allowances and derivatives (ESMA's RTS 2).
ESMA has explained that the Regulation at issue sets out how to determine whether a financial instrument has a liquid market.
Although the said Regulation was developed for the sole purpose of further specifying the MiFIR pre-trade and post-trade transparency obligations for trading venues and investment firms, ESMA considers that the methodology and criteria set out therein for assessing whether a sovereign bond has a liquid market are also relevant, and should serve as a reference, for the purpose of Article 20(3) of MiFID II.
It seems that investment firm or market operator engaging in matched principle trading in an OTF must be prepared for strict oversight of the competent authority.
This is to ensure that such trading does not give rise to conflicts of interest between the investment firm or market operator and its clients.
In addition, the investment firm or market operator of an OTF is obliged to provide the competent authority with information explaining its use of matched principal trading.
Market making in an OTF
Investment firms or market operator operating an OTF are allowed to engage another investment firm to carry out market making on an OTF on an independent basis.
Article 20(5) MIFID II
Member States shall not prevent an investment firm or a market operator operating an OTF from engaging another investment firm to carry out market making on that OTF on an independent basis.
For the purposes of this Article, an investment firm shall not be deemed to be carrying out market making on an OTF on an independent basis if it has close links with the investment firm or market operator operating the OTF.
An investment firm shall not be deemed to carry out market making on an OTF on an independent basis if it has close links (as defined under Article 4(1)(35) of MiFID II) with the investment firm or market operator operating the OTF.
ESMA recalled that, under Article 18(4) of MiFID II, an investment firm operating an OTF must have arrangements in place to clearly identify and manage the potential adverse consequence for the operation of the OTF and its users of any conflict of interest between the interest of the OTF, the investment firm operating the OTF and the sound functioning of the OTF.
More generally, ESMA highlighted that investment firms must maintain and operate effective organisational and administrative arrangements with a view to taking all reasonable steps to prevent conflicts of interest from adversely affecting the interests of clients.
CCPs as OTFs?
Clearing thresholds
Similarly to MTFs, and unlike regulated markets, positions on an OTF count towards EMIR clearing thresholds (contracts concluded in OTFs for EMIR purposes are considered OTC).
EMIR reporting
EMIR reporting requirement covers all derivatives, hence positions on all trading venues (MTFs, OTFs and regulated markets) and OTC are equally covered.
REMIT carve-out
OTFs as new platforms appearing with the MiFID II date of entry into force are particularly important for the delineation of the so-called REMIT carve-out, and, hence, also determine in practice the extent of the MiFID II scope.
In the Questions and Answers on MiFID II and MiFIR market structures topics (ESMA70-872942901-38, Question 17 of 3 October 2017) ESMA underlined that a trading platform that is authorised as an OTF based on trading financial instruments can, in addition, offer trading in REMIT carve-out” contracts (i.e. in wholesale energy contracts that must be physically settled), however, an OTF would not be compliant with MiFID II if trading is offered in C(6) REMIT wholesale energy products only.
In the Answer 18 of the same date ESMA also cleared ambiguities regarding the scope of MiFID II/MiFIR provisions applicable to an OTF engaged in trading in REMIT carve-out contracts (for details see REMIT carve-out).
Compliance costs and business' perspectives
On the side of expenses there will be one‑off costs for firms, either existing investment firms or firms new to regulation, who want to run an OTF to vary their permissions or apply to be authorised.
Another driver of compliance costs of existing trading systems will be requirements imposed on an OTF, restrictions on own account trading including.
Given the legal set-up for OTFs has started to apply with the MiFID II entry into force (3 January 2018), before that date there were no practical examples of functioning OTF business ventures.
Some markets positioning themselves for an OTF operated before MiFID II entry into force as the so-called non-MTFs, but there was, generally, the uncertainty before 3 January 2018 as regards the overall extent, to which platforms will register as OTFs.
It was expected that with the introduction of OTFs as a new category of trading venue for non-equity instruments, many new trading venue providers that under MiFID I operated outside a regulated environment (e.g. dark pools, crossing networks, voice brokerage systems) would emerge (Risk Assessment On the temporary exclusion of exchange traded derivatives from Articles 35 and 36 of MiFIR of exchange traded derivatives from Articles 35 and 36 of MiFIR, 04 April 2016, ESMA/2016/461, p. 20).
For calculating compliance costs, some estimates revolved around 25 impacted venues that would be classified as OTFs (Europe Economics, Data Gathering and Cost Analysis on Draft Technical Standards Relating to the Market Abuse Regulation, 6 February 2015, p. 14).
According to Article 19(10) of MiFID II ESMA is required to publish and keep up to date a list of all OTFs on its website.
The register contains data related to the European Union and European Economic Area (EEA) / European Free Trade Association (EFTA) States.
This list contains information on the services an OTF provides (i.e. the asset classes of financial instruments traded on the OTF) and entails the unique code (Market Identifier Code - MIC) established by ESMA in accordance with Article 65(6) identifying the OTF for use in reports in accordance with Articles 6, 10 and 26 of MiFIR.
The register, as visited on 9 January 2018, was populated with data regarding the following OTFs: Aurel BGC, CAPI OTF, CIMD OTF, Kepler Cheuvreaux, Powernext SAS, TSAF OTC.
Steven Maijoor, ESMA Chair, while referring to 72 OTFs authorised and included in the ESMA register on 21 June 2018 assessed this new category “is already well accepted” (ESMA70-156-427).
| Organised Trading Facility (OTF) - Page 2 |
Page 2 of 4
Questions and Answers on MiFID II and MiFIR market structures topics, ESMA70-872942901-38
5 Multilateral and bilateral systems
5.1 General
Question [Last update: 07/07/2017]
Article 18(3) of MiFID II requires that investment firms and market operators operating an MTF or OTF establish, publish and maintain and implement transparent and non-discriminatory rules, based on objective criteria, governing access to its facility. A similar requirement is applied to regulated markets through Article 53(1) of MiFID II. What sort of behaviour or restrictions should be considered as non-objective, or discriminatory?
Answer
One of the benefits of more on-venue, pre-trade transparent trading is to broaden access to liquidity for market participants. In order for these benefits to be fully realised, it is important that trading venues do not have restrictive criteria governing their access, which place unreasonable restraints on certain market participants’ access to particular liquidity pools.
In particular, ESMA does not consider the following arrangements to be in compliance with Articles 18(3) and 53(1) of MiFID II. This is not, however, an exhaustive list of arrangements which are non-objective and discriminatory.
a) Trading venues should not require members or participants to be direct clearing members of a CCP.
Given the protections afforded to non-clearing members under MiFIR and EMIR, as well as the rules on straight through processing (STP), a trading venue should not require all its members or participants to be direct clearing members of a CCP. Trading venues may however require members or participants to enter into, and maintain, an agreement with a clearing member as a condition for access when trading is centrally cleared.
b) For financial instruments that are centrally cleared, trading venues should not allow members or participants to require other members or participants to be enabled before they are allowed to trade with each other.
There are legitimate checks that a trading venue might carry out before allowing a member or participant on to their venue. For example, in markets for non-centrally cleared financial instruments trading venues may wish to carry out credit checks, or ensure that a member or participant has appropriate capital to support the positions it intends to take on the trading venue. In a non-centrally cleared derivatives market, there may be a need for bilateral master netting agreements to be in place between participants before the trading venue can allow their trading interests to interact. Trading venues will also need to be comfortable that potential participants are meeting the regulatory requirements to be a member of a trading venue such as having appropriate systems and controls to ensure fair and orderly trading.
However, in centrally cleared markets, enablement mechanisms whereby existing members or participants of a trading venue can decide whether their trading interests may interact with a new participant’s trading interest are considered discriminatory and an attempt to limit competition. Enablement mechanisms also reduce the transparency around the liquidity available on different trading venues.
c) Trading venues should not require minimum trading activity.
Trading venues should not require minimum trading activity to become a member or participant of a trading venue, as this could restrict the access to the trading venue to large members or participants.
d) Trading venues should not impose restrictions on the number of participants that a participant can interact with.
In a request for quote (RFQ) protocol, a trading venue should not impose limits on the number of participants that a firm can request a quote from. Whilst a firm requesting a quote may, in compliance with Article 28 of MiFID II, want to limit the number of participants it requests quotes from in order to minimise the risk of unduly exposing its trading interest, which could result in it obtaining a worse price, this should not be mandated by the trading venue. For instance, where a smaller firm is requesting a quote to execute a low volume trade, it might be less concerned about the risks of exposing its trading interest, and so happier to request quotes from a larger number of market makers or liquidity providers.
Limiting the number of participants a firm can request quotes from risks restricting the ability of market participants to access liquidity pools, and only sending requests to traditionally larger dealers who they assume might have larger inventories. This simultaneously restricts the ability of the requestor to access the best pool of liquidity and reduces the likelihood of a smaller dealer receiving requests, despite it having a strong trading interest.
5.2 Organised Trading Facilities (OTFs)
Question [Last update: 03/04/2017]
What are the characteristics of an OTF? When is the authorisation for the operation of an OTF required?
Answer
An OTF is a multilateral system, i.e. “a system or facility in which multiple third-party buying and selling interests in financial instruments are able to interact in the system” (Article 4(1)(19) of MIFID II). The OTF definition supplements this overarching definition by further establishing that only buying and selling interests in bonds, structured finance products, emission allowances and derivatives may interact on an OTF in a way that results in a contract and that the execution of orders must be carried out on a discretionary basis.
In addition, two types of systems operated by an OTF are identified in Article 20(6) of MiFID II: (i) systems that cross client orders (without prejudice to the restrictions placed on matched principal trading) and (ii) systems that arrange transactions in non-equities where the operator of the OTF may facilitate negotiations between clients so as to bring together two or more potentially compatible trading interests in a transaction.
Under Section A(8) of Annex I of MiFID II, the operation of an OTF is an investment activity that requires prior authorisation.
ESMA is of the view that an entity should seek authorisation to operate an OTF where the three following conditions are met: a) trading is conducted on a multilateral basis, b) the trading arrangements in place have the characteristics of a system, and c) the execution of the orders takes place on a discretionary basis through the systems or under the rules of the system.
a) Trading is conducted on a multilateral basis: Interaction with a view to trading in a financial instrument is conducted in such a way that a trading interest in the system can potentially interact with other opposite trading interests. As OTFs are required to “have at least three materially active members or users, each having the opportunity to interact with all the others in respect to price formation” (Article18(7) of MiFID II), an OTF user’s trading interests can potentially interact with those of at least two other users. On OTFs, the interaction of user trading interest can take place in different ways, including through matched-principal trading or market-making, within the limits set out in Article 20(2) and 20(5).
b) The trading arrangements in place have the characteristics of a system: MiFIDII/MiFIR is technology neutral and accommodates a variety of “systems”. A system would be easily identified when embedded in an automated system. This would cover a situation where, for instance, the arrangements in place consist of the automated crossing of client trading interests, subject to the exercise of discretion on an OTF. However, other non-automated systems or repeatable arrangements that achieve a similar outcome as a computerised system, including for instance where a firm would reach out to other clients to find a potential match when receiving an initial buying or selling interest, would also be characterised as a system.
Where a firm would, by coincidence and accidentally, receive matching buying and selling interests, and decide to execute those orders internally, such unpredictable circumstances would not qualify as the operation of a system.
c) The execution of the transaction is taking place on the system or under the rules of the system. The execution of the orders would be considered to be taking place under the rules of the system including where, once the trade price, volume and terms have been agreed through a firm, the counterparties’ names are disclosed, the firm steps away from the transaction and the transaction is then legally formalised between the counterparties outside a trading venue.
If an investment firm arranges a transaction between two clients and the clients decide to formalise the trade on a regulated market or an MTF, the transaction would not be considered as taking place under the rules of the system because a transaction cannot be concluded on more than one venue.
ESMA notes that if an investment firm were to arrange transactions on one system and provide for the execution of the transactions on another system for avoidance purposes, the disconnection between arranging and executing would not waive the obligation for the investment firm operating those systems to seek authorisation as an OTF operator.
ESMA highlights that OTFs are only one of the three categories of multilateral trading systems foreseen by MiFID II. Market participants operating a platform that meets the characteristics of a multilateral trading facility should therefore exercise judgment to assess, based on their business model, whether they need to seek authorisation for the operation of a multilateral trading facility (MTF), an OTF or, potentially of a regulated market. See also Question 5 on the differences between an MTF and an OTF and Questions 14 and 15 on systematic internalisers (SIs) and riskless transactions.
Question [Last update: 03/04/2017]
Does the concept of OTF apply to voice trading and, if yes, when an investment firm executing transactions through voice negotiation should be considered as falling under the definition of OTF?
Answer
Yes. MiFID II is technology neutral and the OTF definition includes voice trading in the same way as the definition of regulated markets and MTFs include voice trading systems. An investment firm executing transactions through voice negotiation would be considered as falling under the definition of an OTF where the arrangements in place would meet the conditions set out in Answer 3.
Question [Last update: 03/04/2017]
What distinguishes an OTF from an MTF?
Answer
MTFs and OTFs both are multilateral trading systems that can be operated by an investment firm or a market operator. However, compared to MTFs, OTFs have a number of key distinct features:
a) OTFs may only trade in bonds, structured finance products, derivatives and emission allowance (non-equity instruments);
b) There are less stringent limitations to the type of activities that the operator of the OTF may undertake both in relation to matched principal trading and trading on own account. Additional restrictions apply as an OTF and a SI cannot be operated by the same legal entity;
c) As opposed to regulated markets and MTFs governed by non-discretionary rules, the OTF operator must exercise discretion either when deciding to place or retract an order on the OTF and/or when deciding not to match potential matching orders available in the system;
d) As opposed to regulated markets and MTFs that have members or participants, OTFs have clients. As a consequence, transactions concluded on OTFs have to comply with client facing rules, including best execution rules, regardless whether the OTF is operated by an investment firms or a market operator; and
e) Wholesale energy products that must be physically settled (C6 REMIT) do not qualify as financial instruments when traded on an OTF.
Question [Last update: 03/04/2017]
The operator of an OTF may engage in dealing on own account other than matched-principal trading only with regard to sovereign debt instruments that do not have a liquid market. (Article 20(3) of MiFID II. How should the liquidity of sovereign debt instruments be assessed?
Answer
ESMA notes that RTS 2 sets out how to determine whether a financial instrument has a liquid market.
Although RTS 2 was developed for the sole purpose of further specifying the MiFIR pre-trade and post-trade transparency obligations for trading venues and investment firms, ESMA considers that the methodology and criteria set out in RTS 2 for assessing whether a sovereign bond has a liquid market are also relevant, and should serve as a reference, for the purpose of Article 20(3) of MiFID II.
Question [Last update: 03/04/2017]
On what basis can a third party investment firm carry out market making on an OTF on an independent basis (cf. Article 20(5) of MiFID II)?
Answer
As provided for by Article 20(5) of MiFID II, the operator of the OTF may engage another investment firm to carry out market making on the OTF on an independent basis. The independence test is met when the investment firm carrying out market making has no close links with the operator of the OTF as defined under Article 4(1)(35) of MiFID II.
ESMA recalls that, under Article 18(4) of MiFID II, an investment firm operating an OTF must have arrangements in place to clearly identify and manage the potential adverse consequence for the operation of the OTF and its users of any conflict of interest between the interest of the OTF, the investment firm operating the OTF and the sound functioning of the OTF. More generally, ESMA highlights that investment firms must maintain and operate effective organisational and administrative arrangements with a view to taking all reasonable steps to prevent conflicts of interest from adversely affecting the interests of clients.
Question [Last update: 03/04/2017]
Can an SI and an OTF be operated by the same legal entity when they do not trade the same instruments or class of instruments (e.g. an SI in equities and an OTF in derivatives)?
Answer
No. ESMA is of the view that the very general wording of Article 20(4) of MiFID II introduces a blanket prohibition of the combination of the OTF and SI activities by the same legal entity across asset classes and instruments. This blanket prohibition also addresses circumstances under which an investment firm would be operating an OTF and an SI in different asset classes, while being potentially subject to similar conflicts of interests as the ones associated with being an OTF and an SI in the same asset class or instrument. This would be the case, for instance, with an investment firm operating an OTF in equity derivatives while being an SI in the underlying equities.
Question Last update: 03/04/2017]
Where an investment firm that is an SI has to set up a separate legal entity to operate an OTF (or vice-versa), can those two entities have shared resources?
Answer
Having two separate legal entities operating the OTF and the SI aims at ensuring that each venue is operated to the sole benefit of its respective clients and is not influenced in any way by the activity undertaken by the other venue.
To that end, ESMA is of the view that the two legal entities respectively operating the SI and the OTF should have arrangements in place that prevent information sharing on each other’s relevant activities regarding the operation of the OTF and the SI. This would include for instance having distinct management and operational teams and physical separation of activities. Similarly, whereas some elements of the IT infrastructure could be shared, execution systems would be expected to be segregated and safeguards in place to ensure that there is no information leakage across the SI and the OTF activities. Outsourcing from one legal entity to the other should only be considered where the arrangements in place meet a similar test.
The above is without prejudice to the MiFID II provisions on identification and management of conflicts of interest to be met by each of the two investment firms.
Question Last update: 03/04/2017]
Under which conditions can an OTF connect to other liquidity pools such as an SI or another OTF?
Answer
Article 20(4) of MiFID II limits the circumstances under which an OTF may connect with other liquidity pools by prohibiting orders placed in an OTF to interact with quotes or orders in a SI or with orders in other OTFs. Interaction would occur when buying and selling interests would comingle in the same liquidity pool. Accordingly, an SI quote may not be placed on an OTF. Nor can an order originating from another OTF.
ESMA highlights that a trading interest in an OTF may not be executed against an opposite order or quote on another execution venue. For a transaction to take place, the two opposite trading interests must be placed with the same execution venue. However, this does not prevent the investment firm or the market operator operating an OTF from retracting the order from the OTF and sending it to another OTF, to an SI, an MTF or a regulated market, where consistent with the investment firm’s or the market operator’s execution policy and exercise of discretion.
Question [Last update: 03/04/2017]
When an investment firm operates an OTF, at which level should the best execution policy be set? At the level of the investment firm, at the level of the OTF or both? Would similar requirements apply to a market operator operating an OTF?
Answer
Where an investment firm operates an OTF, ESMA is of the view that the investment firm’s best execution should cover how orders are executed both at the level of the investment firm and at the level of the OTF and, in particular, how discretion is exercised at each stage.
Firstly, an investment firm operating an OTF should, in the same way as other investment firms that execute client orders, have a firm-level execution policy setting out the various execution venues, including its own OTF, that it will be considering when receiving a client order and explain in which circumstances an execution venue would prevail over the others.
Secondly, the investment firm should have either a separate policy or an additional section in the firm-level execution policy governing how, when a client order is sent to the OTF, the best possible result for the client is achieved taking into account the trading interests in the system and the different execution mechanisms that may be available on the OTF, such as voice execution, electronic RFQ or order book.
As the exercise of discretion by the investment firm in its OTF operator capacity is to be in compliance with its execution policy, the document should also set out in details the area(s) in which the OTF operator intends to exercise discretion and the basis on which such discretion will be exercised (Article 20(6) of MiFID II).
Equivalent requirements apply to a market operator operating an OTF. In this regard, a market operator would need to have a best execution policy in place, setting out the conditions under which an order received by a client may be executed on its OTF, as described above.
Question [Last update: 03/04/2017]
Does the exercise of any form of discretion mean that a venue is an OTF?
Answer
No. Article 20(6) of MiFID II sets out that “the market operator or the investment firm operating an OTF must exercise discretion only in either or both of the following circumstances:
a) When deciding to place or retract an order on the OTF they operate;
b) When deciding not to match a specific client order with other orders available in the systems at a given time, provided it is in compliance with specific instructions received from a client and with its obligations in accordance with article 27.
For the system that crosses client orders, the investment firm or the market operator operating the OTF may decide if, when, and how much of two or more orders it wants to match within the system. [...] with regards to a system that arranges transactions in non-equities, the investment firm or market operator operating the OTF may facilitate negotiations between clients so as to bring together two or more potentially compatible trading interest in a transaction”.
ESMA understands “execution on a discretionary basis” and “exercise of a discretion” as meaning that, in the circumstances foreseen in Article 20(6), the operator of the OTF has options to consider for the execution of a client’s order and exercises a judgement as to the decision to make and the way forward.
As suggested by Article 20(6), ESMA is of the view that the exercise of discretion can usefully be split into a) order discretion and b) execution discretion.
a) Exercise of discretion at order level
When an investment firm or a market operator receives an order from a client, the “order discretion” refers to the judgement exercised by the OTF operator whether to place the order at all on the OTF, whether to place the whole order or just a portion of it on the OTF, and when to do so. This may be the case for instance where an investment firm would receive a buy order for a 500 lots and would decide to place an order for 200 lots only on the OTF, the remaining 300 lots being executed elsewhere.
Similarly, and as opposed to the operator of an MTF which may not withdraw an order from the MTF at its own initiative unless for fair and orderly market purposes, the operator of the OTF is expected to make a judgement as to whether and when an order should be retracted from the OTF.
This may be the case where, at a given point of time, the OTF operator considers that a more favourable outcome would be obtained by executing the order on another execution venue foreseen in the best execution policy. The OTF operator may also have placed the order on the OTF, sent it to another trading venue simultaneously, subsequently decided to have the order executed on the trading venue and retracted it from the OTF.
The exercise of order discretion would always have to comply with the OTF best execution policy and with client order handling rules. Where clients would be providing a specific instruction to the operator of the OTF, the OTF operator would not be considered as exercising order discretion when complying with that specific instruction.
b) Exercise of discretion at execution level
Under Article 20(6), the exercise of discretion at execution level has to be in compliance with client specific instructions and the best execution policy. ESMA is of the view that the mere implementation of client specific instructions or of best execution obligations would not be the exercise of discretion.
The operator of the OTF is expected to exercise a judgement as to if, when, and how much of two matching orders in the system should be matched. For instance, assuming a buy side order for 500 bonds and an opposite order of 200 bonds have been placed into the OTF, the operator of the OTF would exercise discretion when deciding whether the 500 buy side order should not be matched with the sell side order.
Finally, ESMA highlights that the exercise of discretion, be it “order discretion” or “execution discretion”, should not be just a possibility foreseen in the rules of the OTF and in the best execution policy of the OTF operator. Discretion has to be actually implemented by the operator of the OTF as part of its ordinary course of business and should be a key part of its activities. It is not expected that any quantitative threshold would be set to assess the exercise of discretion. However, as provided for under Article 20(7) of MiFID II, at the time of authorisation or on ad-hoc basis, the market operator or the investment firm operating an OTF should be able to provide to its national competent authority a detailed description of how discretion will be exercised and in particular when an order may be retracted from the OTF and when and how two or more client orders will be matched in the OTF. ESMA also highlights that the OTF operator should be able to explain to its national competent authority the rationale underpinning the exercise of discretion, such as the set of reasons and the logical basis for not matching two opposite buying and selling interests. Random placing, retracting, matching or non-matching of orders on the OTF would not be considered as the exercise of discretion.
Likewise, the exercise of pre-trade controls by the operator of the OTF to ensure fair and orderly trading would not qualify as the exercise of discretion. Post-trade decisions, for example over where transactions are settled, are not relevant either for the purposes of these provisions. Similarly, the decision to enter into a client relationship in compliance with OTF rules on non-discriminatory access does not constitute discretion under Article 20(6).
Question [Last update: 03/04/2017]
Does discretion have to be exercised on an order by order basis?
Answer
ESMA is of the view that discretion at order level (see Answer 12) does not have to be exercised order by order. As an example, the OTF operator may consider, at a given point in time that some or all orders of a specific size in a specific instrument should be retracted from the OTF as more favourable conditions are temporarily available elsewhere. However, the OTF operator must have the ability to exercise discretion at order level if circumstances so require, for instance in case of prior execution of an order on another trading venue.
Conversely, ESMA is of the view that, at execution level, discretion whether not to match two potential matching buying and selling interests can only be meaningfully exercised at order level.
Question [Last update: 03/04/2017]
Does a fully automated system exclude the exercise of discretion and should therefore be automatically classified as an MTF?
Answer
No. MiFID II is ‘technology neutral’ and permits any trading protocol to be operated by an OTF, provided it is consistent with fair and orderly trading and the exercise of discretion.
ESMA is of the view that the exercise of discretion as to if and when to place or retract an order could possibly be automated through artificial intelligence and algorithms, without necessarily the exercise of human judgement on a case by case basis. Conversely, human intervention is not necessarily sufficient to prove the exercise of discretion. Human intervention that is not based on the exercise of human judgement (for instance, only consisting in the random placing or retracting or matching/non-matching of orders) would not be considered as the exercise of discretion.
When discretion is exercised at execution level, i.e. when deciding if, when or how much of two or more trading interests should (or should not) be matched, ESMA is of the view that the exercise of discretion would not preclude the use of automated systems, provided that certain conditions are met. In particular, the sophisticated algorithms supporting automated matching would need to anticipate the circumstances under which the orders would not be matched; they would also have the capacity to ensure that the decision to match (or not to match) two opposite trading interests is in compliance with the best execution policy or a client specific instruction. As one of the differentiating factors from execution algorithms operated by MTFs, the algorithms operated by the OTF would be expected to take into account external market factors or other external source of information to demonstrate the exercise of discretion.
Question Last update: 03/10/2017]
Can an OTF offer trading in C(6) REMIT wholesale energy products only?
Answer
No. Under Article 4(1)(23) of MiFID II, an organised trading facility (OTF) is a multilateral trading system which organises the interaction of multiple third party buying and selling interests in bonds, structured finance products, emission allowances and derivatives, i.e. in financial instruments.
Accordingly, to be authorised as an OTF, a multilateral trading system must offer trading in the financial instruments listed above, without prejudice to the other requirements to be met for such authorisation. However, a trading platform that is authorised as an OTF based on trading financial instruments can, in addition, offer trading in wholesale energy contracts that must be physically settled ( “REMIT carve-out” contracts).
ESMA highlights that the OTF must ensure that genuine trading in financial instruments takes place on the OTF to be authorised, and retain authorisation, as an OTF, with appropriate staff, IT, financial and other resources being devoted to this activity. Trading in financial instruments should not be designed for the sole purpose of obtaining an OTF license and with the end-objective of trading REMIT carve-out contracts almost exclusively.
Question [Last update: 03/10/2017]
When an OTF authorised to trade financial instruments also trades REMIT wholesale energy products, i.e. in non-financial instruments, what are the applicable MiFID II/MiFIR provisions?
Answer
MiFID II/MiFIR provisions apply to the operation of an OTF trading financial instruments. Where a person seeks authorisation as an OTF and intends to offer trading in REMIT carve-out contracts as well, a detailed description of the REMIT carve-out trading activity should be included in the authorisation file so that the competent authority can understand and assess the potential impact of REMIT carve-out trading on the investment firm or market operator operating the OTF and on trading in financial instruments. The information to be provided is set out in ITS 19 (Commission Implementing Regulation (EU) 2016/824 of 25 May 2016 laying down implementing technical standards with regard to the content and format of the description of the functioning of multilateral trading facilities and organised trading facilities and the notification to the European Securities and Markets Authority according to Directive 2014/65/EU of the European Parliament and of the Council on markets in financial instruments).
Where an investment firm or market operator operating an OTF has been authorised and intends to additionally offer trading in REMIT carve-out products, a detailed description of the REMIT carve-out trading activity should be provided to the competent authority in due course before the start of such trading activities.
The management body of the investment firm (or the market operator) operating the OTF is responsible for defining, approving and overseeing the organisation of the firm or market operator for the provision of investment services and activities, taking into account the nature, scale and complexity of its business and all the requirements the firm has to comply with. ESMA is of the view that the responsibilities of the management body extends to the non-financial instrument trading activity of the OTF as they may have an impact on the investment activities provided by the investment firm (or the market operator). This also applies to the management body’s responsibilities governing the investment firm (or market operator)’s internal policy setting out, among other things, the activities, products and operations offered or provided in accordance with risk tolerance of the firm (or the market operator).
More generally, ESMA highlights that a market operator or an investment firm operating an OTF trading both financial instruments and REMIT carve-out products should identify, prevent or otherwise manage any potential adverse consequences that trading in REMIT carve-out products may have on trading in financial instruments and on its ability to meet its MiFIDII/MiFIR obligations on an on-going basis. Upon request, the operator of the OTF should be able to explain to the competent authority the procedures and arrangements put in place to that effect.
Question [Last update: 03/10/2017]
How do the OTF best execution obligations apply when third-party brokers are clients of the OTF or when these brokers provide Direct Electronic Access (DEA) (see Article 4(1)(41) of MiFID II)?
Answer
When an investment firm or a market operator operating an OTF receives orders or indications of interest from a broker acting on behalf of its own clients, the operator of the OTF should be implementing its own best execution policy when executing the order from the broker orders as it owes its user clients (the broker) the duty of best execution. The broker should determine that the OTF it selects allows it to comply with its best execution obligations towards its own clients. To that end, the broker should conduct a performance assessment of the OTF including how discretion is exercised. In the specific case of DEA to an OTF, the DEA order is entered in the OTF client’s name (the broker) and the OTF operator should execute the DEA order as it would for any OTF client order. Alternatively, the operator of the OTF may decide not to permit DEA to its system. ESMA notes that a DEA order could be considered as a client specific instruction to the broker providing the DEA arrangement to its clients.
Question [Last update: 29/05/2018]
Can an OTF arrange or trade strategies including an equity leg?
Answer
Strategies that include futures contracts, the contingent trade of a basket of equities or delta one financial instruments can be arranged by an investment firm, as a provider of investment services listed under points (1), (2) or (3) in section A of Annex I of MiFID II.
This includes a strategy in which one party agrees to buy an equity and to execute a short derivative in the equity and the other party agrees to sell the equity and to execute the long derivative.
ESMA considers that an investment firm operating an OTF could arrange such strategies provided that the equity leg is not executed on the OTF system, since Article 4(1)(23) of MiFID II defines OTFs as multilateral systems where only non-equity instruments can be traded.
This restriction also applies to strategies composed of a look-alike equity leg, including a forward trade.
In addition, for the purpose of market integrity, ESMA recalls that double counting should be avoided.
Thus, an OTF should only provide transparency information, transaction and best execution reports for transactions that are concluded on its system and considered as taking place under the rules of its system.
In case of a strategy composed of an equity leg concluded on another venue while the derivative is concluded on the OTF system, the OTF is subject to reporting requirements for the derivatives’ leg.
| Organised Trading Facility (OTF) - Page 3 |
Page 3 of 4
Questions and Answers on MiFID II and MiFIR investor protection and intermediaries topics, ESMA35-43-349
1 Best execution
Question 16 [Last update: 3 October 2017]
How do the OTF best execution obligations apply when third-party brokers are clients of the OTF or when these brokers provide Direct Electronic Access (DEA) to the OTF (see Article 4(1)(41) of MiFID II)?
Answer 16
When an investment firm or a market operator operating an OTF receives orders or indications of interest from a broker acting on behalf of its own clients, the operator of the OTF should be implementing its own best execution policy when executing the order from the broker as it owes its user clients (the broker) the duty of best execution. The broker should determine that the OTF it selects allows it to comply with its best execution obligations towards its own clients. To that end, the broker should conduct a performance assessment of the OTF including how discretion is exercised.
In the specific case of DEA to an OTF, the DEA order is entered in the OTF client’s name (the broker) and the OTF operator should execute the DEA order as it would for any OTF client order. Alternatively, the operator of the OTF may decide not to permit DEA to its system.
ESMA notes that a DEA order could be considered as a client specific instruction to the broker providing the DEA arrangements to its clients (see Q.16).
MiFIR recitals 8 and 9:
(8) In order to make Union financial markets more transparent and efficient and to level the playing field between various venues offering multilateral trading services it is necessary to introduce a new trading venue category of organised trading facility (OTF) for bonds, structured finance products, emissions allowances and derivatives and to ensure that it is appropriately regulated and applies non-discriminatory rules regarding access to the facility. That new category is broadly defined so that now and in the future it should be able to capture all types of organised execution and arranging of trading which do not correspond to the functionalities or regulatory specifications of existing venues. Consequently, appropriate organisational requirements and transparency rules which support efficient price discovery need to be applied. The new category encompasses systems eligible for trading clearing-eligible and sufficiently liquid derivatives.
It should not include facilities where there is no genuine trade execution or arranging taking place in the system, such as bulletin boards used for advertising buying and selling interests, other entities aggregating or pooling potential buying or selling interests, electronic post-trade confirmation services, or portfolio compression, which reduces non-market risks in existing derivatives portfolios without changing the market risk of the portfolios. Portfolio compression may be provided by a range of firms which are not regulated as such by this Regulation or by Directive 2014/65/EU, such as central counterparties (CCPs), trade repositories as well as by investment firms or market operators. It is appropriate to clarify that where investment firms and market operators carry out portfolio compression certain provisions of this Regulation and of Directive 2014/65/EU are not applicable in relation to portfolio compression. Since central securities depositories (CSDs) will be subject to the same requirements as investment firms when providing certain investment services or performing certain investment activities, the provisions of this Regulation and of Directive 2014/65/EU should not be applicable to firms that are not regulated thereby when carrying out portfolio compression.
(9) That new category OTF will complement the existing types of trading venues. While regulated markets and MTFs have non-discretionary rules for the execution of transactions, the operator of an OTF should carry out order execution on a discretionary basis subject, where applicable, to the pre-transparency requirements and best execution obligations. Consequently, conduct of business rules, best execution and client order handling obligations should apply to the transactions concluded on an OTF operated by an investment firm or a market operator. In addition, any market operator authorised to operate an OTF should comply with Chapter 1 of Directive 2014/65/EU regarding conditions and procedures for authorisation of investment firms. The investment firm or the market operator operating an OTF should be able to exercise discretion at two different levels: first when deciding to place an order on the OTF or to retract it again and second when deciding not to match a specific order with the orders available in the system at a given point in time, provided that that complies with specific instructions received from clients and with best execution obligations.
For the system that crosses client orders the operator should be able to decide if, when and how much of two or more orders it wants to match within the system. In accordance with Article 20(1), (2), (4) and (5) of Directive 2014/65/EU and without prejudice to Article 20(3) of Directive 2014/65/EU, the firm should be able to facilitate negotiation between clients as to bring together two or more potentially compatible trading interests in a transaction. At both discretionary levels the OTF operator must have regard to its obligations under Articles 18 and 27 of Directive 2014/65/EU. The market operator or investment firm operating an OTF should make clear to users of the venue how they will exercise discretion. Because an OTF constitutes a genuine trading platform, the platform operator should be neutral. Therefore, the investment firm or market operator operating the OTF should be subject to requirements in relation to non-discriminatory execution and neither the investment firm or market operator operating the OTF nor any entity that is part of the same group or legal person as the investment firm or market operator should be allowed to execute client orders in an OTF against its proprietary capital.
For the purpose of facilitating the execution of one or more client orders in bonds, structured finance products, emission allowances and derivatives that have not been declared subject to the clearing obligation in accordance with Article 5 of Regulation (EU) No 648/2012 of the European Parliament and of the Council ( 1 ), an OTF operator is permitted to use matched principal trading within the meaning of Directive 2014/65/EU provided the client has consented to that process. In relation to sovereign debt instruments for which there is not a liquid market, an investment firm or market operator operating an OTF should be able to engage in dealing on own account other than matched principal trading. When matched principal trading is used all pre-trade and post-trade transparency requirements as well as best execution obligations must be complied with. The OTF operator or any entity that is part of the same group or legal person as the investment firm or market operator should not act as systematic internaliser in the OTF operated by it. Furthermore, the operator of an OTF should be subject to the same obligations as an MTF in relation to the sound management of potential conflicts of interest.
| Organised Trading Facility (OTF) - Page 4 |
Page 4 of 4
29 May 2018 - Questions and Answers on MiFID II and MiFIR market structures topics (ESMA70-872942901-38) updated: clearance on whether an OTF can arrange or trade strategies including an equity leg
3 October 2017 - Questions and Answers on MiFID II and MiFIR market structures topics (ESMA70-872942901-38) updated: clearance on the OTF and the REMIT carve-out interrelations
MiFID II Annex I point 9
MiFIR, Recitals 8 and 9
|
|
|
|
No comments:
Post a Comment