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V MiFID's impact on MTFs and the trading venue landscape in Europe

MiFID regulation concerning order routing requirements, market transparency and best exe­cution will massively impact the trading venue landscape in Europe. The regulatory changes in these areas will be discussed in the following. Afterwards, scenarios will be outlined that assess the impact of the regulatory changes with a special focus on MTFs.

Order routing:

In comparison to the regulatory setup of the ISD of 1993, MiFID does not provide for a con­centration rule: MiFID does not explicitly address the question of allowing member states to define "concentration rules" or "default rules", but according to Article 69 MiFID the ISD shall be repealed with the application of the MiFID in member states. Thus, in contrast to current concentration or default rules, member states will not be enabled to privilege Regulated Mar­kets against other trading venues any longer. From a regulatory perspective, attracting order flow and therefore liquidity from the traditional exchanges will be eased for MTFs and Sys­tematic Internalisers although going hand in hand with increased regulatory costs (especially for Systematic Internalisers).

Market transparency:

Concerning market transparency, most of the rules concerning MTFs are similar to those for Regulated Markets. Pre-trade transparency requirements for MTFs and Regulated Markets are codified in MiFID Article 29 and Article 44 respectively and require both to "make public current bid and offer prices and the depth of trading interests at these prices" for shares ad­mitted to trading on a Regulated Market. Article 16 of the "Level 2" draft implementing regula­tion further qualifies this requirement depending on the market model of the system, but re­gardless whether the entity is classified as a Regulated Market or as an MTF:

(i) Entities operating a continuous auction order book trading system shall make public "the aggregate number of orders and of the shares those orders represent at each price level, for the five best bid and offer price levels"⁵².

(ii) Entities operating a quote-driven trading system shall make public "the best bid and offer by price of each market maker in that share, together with the volumes attaching to those prices"⁵³.

(iii) Entities operating a periodic auction trading system shall make public "the price at which the auction trading system would best satisfy the system's trading algorithm and the volume that would potentially be executable at that price"⁵⁴.

(iv) Entities that are not covered wholly by the aforementioned classifications either because they are "hybrid systems (..) or because the price determination proc­ess is of a different nature, (..) shall maintain a standard of pre-trade transpar­ency that ensures that adequate information is made public as to the level of or­ders or quotes for that share, as well as the level of trading interest in that share"⁵⁵.

Exceptions for the pre-trade obligations are common to MTFs and Regulated Markets as well. MiFID Articles 29(2) and 44(2) respectively open up the possibility that the competent authorities are able to waive the obligation for MTFs and Regulated Markets to publish pre-trade information. Waiving is possible depending on the market model, type and size of the order. In particular, waiving should be enabled for transactions that are large in scale com­pared with normal market size for the share. Concerning market models, Article 17(1) of the "Level 2" draft implementing regulation concretizes the requirements for those waivers. Either the system operated by a Regulated Market or an MTF must be using a widely published and generally considered reliable reference price imported from another trading venue for its own price determination – like crossing systems – or it has to formalise negotiated transactions⁵⁶. Those negotiated transactions have either to be made at or within the volume weighted spread for the size of the trade reflected on the order book or the quotes currently available on the system or have to be subject to conditions other than the current market price of the share. Concerning order types, orders that are held in an order management facility (like ice­berg orders or stop orders) are also excluded from pre-trade transparency requirements.

The commonalities for Regulated Markets and MTFs are existent for the obligations concern­ing post-trade transparency⁵⁷ as well.

Best execution:

MiFID requires Investment Firms to execute orders on terms most favourable to the client. Article 21(1) MiFID requires that they "take all reasonable steps to obtain .. the best possible result .. taking into account price, costs, speed, likelihood of execution and settlement, size, nature or any other consideration relevant to the execution of the order." For determining the relative importance of those factors, Investment Firms shall – according to Article 44 of the "Level 2" draft implementing directive – take into account the status of the client (retail or pro­fessional), the nature of the order (size and type), characteristics of the financial instrument the order is subject to, and characteristics of the venue to which that order can be routed. As a result, Investment Firms have – according to Article 21 (2) and (3) MiFID – to specify an order execution policy which "shall include, in respect of each class of instruments, informa­tion on the different venues where the investment firm executes its client orders and the fac­tors affecting the choice of execution venue. It shall at least include those venues that enable the investment firm to obtain on a consistent basis the best possible result for the execution of client orders'⁵⁸. However, the European legislation does not oblige Investment Firms to connect to every trading venue at any costs, if the "costs of connecting to certain venues would be disproportionate and lead to a heavy overall increase in fees'⁵⁹. Investment Firms have to update their order execution policy "on a regular basis'⁶⁰. Furthermore, according to Article 21(5) they are required to prove on request that they executed a client's orders in ac­cordance with this order execution policy.

Given that Regulated Markets and MTFs are on equal terms concerning market transparency and that order routing can be conducted equitably to both types of venue and that there is no possibility for member states to setup a concentration rule, the status of MTFs will de jure be strengthened by MiFID. However, as there are strong network externalities on European markets, the third aspect – best execution – may play a crucial role in assessing the de facto status of MTFs in the new regulatory environment. There is a small but powerful concretion in the "Level 2" draft implementing measures concerning the form of best execution ex­pressed by the "Level 1" framework legislation. Depending on which form of best execution will be finally adopted, there may be significantly different prospects for MTFs in Europe. In the following, we will explore the different impact of both forms of best execution regulation by developing and outlining corresponding scenarios:

Scenario 1: Best execution as a process

The "Level 1" directive expressed best execution to be a process, i.e. executing orders in accordance with the best execution policy would mean that orders have to be routed to one of the venues included in the order execution policy provided that these execution venues enable to obtain the best result on a consistent basis. Furthermore, the "Level 1" directive does not define a specific priority among the different criteria that should be taken into account for determining the best result – neither for retail nor for institutional customers. Therefore, overall liquidity will be the key driver for routing decisions instead of singular best prices at specific venues. Thus, (potential) new venues and MTFs will presumably not be able to contest the established markets due to their demonstrated efficiency and concentration of liquidity eyed per instrument based on the existing network externalities. In this scenario, in a post MiFID world, MTFs will likely only be playing a mi­nor role in share trading and head for niche areas. Potential future business models could cover two key niche areas:

i) One promising niche for MTFs could be crossing/reference price systems, i.e. a system "where the price is determined by a reference price generated by another system"⁶¹, or providing systems/models that enable to explore the possibility of negotiated transactions. As in both cases pre-trade transparency can be waived, specific investors' needs like block trading, where the anonymity of orders and traders is maintained, can be addressed by MTFs. But as MiFID sets up a level playing field between Regulated Markets and MTFs, these needs can be satisfied by the Regulated Markets as well. Some Regulated Markets already offer such crossing network type models⁶².

ii) Investment Firms are faced with significant regulatory costs if they are classified as a Systematic Internaliser, i.e. the costs they would have to bear in order to be compliant with the pre-trade transparency requirements according to MiFID Article 27 and the associated trading risks. Therefore, they will try to avoid such a classi­fication at all. One way to achieve this would be to team-up with one or more other Systematic Internalisers and jointly set-up an MTF applying a quote-driven market maker system. Classification as a Systematic Internaliser would be avoided, as the joint system is multilateral rather than bilateral and therefore regu­latory costs relating to the requirements on MTFs could be borne jointly. But it would not be possible any longer for the Investment Firms to internalise the order flow in its purest form as the model has to provide the accessibility of the order flow also to the respective other market makers.

Scenario 2: Best execution on an order-by-order basis

The current "Level 2" draft implementing directive and the background notes⁶³ issued by the EU Commission express that Investment Firms have to evaluate on an order-by-order basis which of the venues included in their order execution policy is providing the best possible result when the order arrives and to route the client order to this specific venue⁶⁴. Furthermore, the "Level 2" draft implementing directive is explicit concerning a priority among the criteria for determining the best result: For retail client orders the total consideration, i.e. the price of the financial instrument plus the costs related to execution (the gross price), determines the best possible result⁶⁵ and thereby sets a clear bench­mark for the execution of retail client orders⁶⁶.

Provided the idea of best execution on an order-by-order basis expressed by the "Level 2" directive will be realised, the landscape of European trading venues might face rele­vant changes and the prospects for MTFs to enter the market may improve. In this envi­ronment, MTFs (or entrants that set-up new Regulated Markets) could contest the estab­lished Regulated Markets, as the existing network externalities would only protect them for institutional order flow: For retail order flow, the total liquidity concentrated at a trading venue would no longer be a critical factor, as for retail orders the best gross price would become the decisive factor. If an MTF provides at a specific point in time the best (gross) price it will be able to attract the (retail) order flow although on an overall basis it only of­fers minor liquidity.

The bottom line would be that de facto a system comparable to the US NMS would form in Europe, with the necessity to route retail orders to the venue offering the best price in terms of total consideration. This would also imply a tendency towards a "European Trade-Through Rule" for retail orders among the venues included in the best execution policy of an Investment Firm. However in contrast to the centralised NMS system, the European analogue would be decentralised with a multiplicity of individual routing sys­tems. Each Investment Firm would have to set up/buy technical facilities having the func­tionality of Smart Order Routing systems with the task to decide in real-time for each in­coming order to which trading venue (among the venues included in its best execution policy) it should route this order to fulfil the Investment Firm's best execution obligation for this specific order. As a basis for this decision, data from a multiplicity of trading ven­ues would be needed in real-time, which would create demand for Liquidity Aggregation systems⁶⁷. As best execution and client order handling are part of the "Level 2" directive, they need to be transposed into the national legal framework of each EU member state, which leaves some flexibility as to the form and means of implementation on the one hand but induces a risk of regulatory arbitrage on the other hand.

VI Conclusion and outlook

With RegNMS in the US and MiFID in the EU, regulators on both sides of the Atlantic catch up with recent years' technological advances. Improvements concerning market models, trading systems and execution concepts as well as increased requirements of (institutional) investors concerning market access, execution speed and execution quality are reflected in these new legislations. Both RegNMS and MiFID set-up a level playing field among execu­tion venues by addressing market transparency, order routing and best execution require­ments. MTFs represent a new class of trading venues in Europe introduced by the MiFID – they are the European analogue of ECNs. MiFID puts MTFs and Regulated Markets on equal terms regarding the fact that orders can be routed equitably to these types of venues due to the abolishment of the possibility for EU member states to specify a concentration rule. Regulated Markets and MTFs have to fulfil similar requirements for pre- and post-trade transparency. Overall, the de jure status of MTFs will be strengthened in a post-MiFID world.

Section V of this paper discusses that assessing the future de facto status largely depends on which of the two forms of best execution, expressed by the "Level 1" and "Level 2" direc­tives respectively, will be adopted. The European Securities Committee and subsequently the European Parliament are inspecting the current "Level 2" draft implementing measures and verify that those measures comply with the framework set by the "Level 1" directive. A discussion on whether the "Level 2" documents go beyond the scope defined by the "Level 1" text concerning best execution is likely to occur before the measures are ready for adoption by the Commission of the European Communities.

If best execution as a process will be adopted, MTFs probably will only be able to attract li­quidity in certain niches. If on the other hand best execution on an order-by-order basis will be adopted and a "gross price only" benchmark will be specified for retail orders, MTFs (and other new market entrants) would be enabled to contest established markets especially con­cerning retail trading. Showing the best bid or offer in terms of the total consideration, i.e. gross price, would become the crucial factor to decide on the respective venue out of the venues defined in the best execution policy of the Investment Firm. Given these order routing requirements, technologies like Smart Order Routing and Liquidity Aggregation would be­come more important in Europe and require significant investments especially for smaller European Investment Firms to comply. The order-by-order approach together with the retail price benchmark would bring the European landscape of trading venues closer to the US setup and might have a relevant impact especially on the retail trading value chain.

Literature