Dealing in Securities: The Law and Regulation of Sales and Trading in Europe 9781526514363, 9781526514394, 9781526514387

Table of contents :
Preface
Table of Statutes
Tables of European Legislation and Materials
Abbreviations
1 Introduction
2 Authorising and regulating securities dealing in Europe
The universal public policy imperative of authorisation
Determining the need for authorisation
Deciding on whether the investment and the service are regulated
Providing a service out of the jurisdiction, in the jurisdiction and into the jurisdiction
Did the investor request the service? Solicitation and reverse solicitation
Characteristic performance for services into the jurisdiction from abroad
The European dual track system
Harmonisation: the European single market in financial services
Investment Services Directive 1993
MiFID II intra-EU and third country provision of services
Providing services from one Member State to another: branch and services passports
Third country regime under MiFID II
Pan-European reverse solicitation
Investment Firm Review: the evolution of the third country regime
The approach of the single market to third countries: co-existence of national and international regimes
UK perimeter guidance
Brexit
The impact of Brexit on authorisation regimes
The centrifugal force of national interests
Empty shells and the gravitational pull of the European Central Bank
Annex
Investment services and activities in MiFID II
Ancillary services in MiFID II
Investment instruments in MiFID II
Client categories in MiFID II
3 Dealing in securities and the primary obligations
Orders, RFQs and executions in the context of securities dealing
Client orders and indications of interest
Simultaneous execution
Receipt of orders
Record Keeping
Trade booking
How to understand Annex I of MiFID
Conflicts of interest
Conduct of business obligations
Client classification
Communication with clients
Providing a written agreement
Assessing suitability when giving investment advice
Best execution
Inducements
Market Transparency
Pre-trade transparency
Post-trade transparency
Regulatory and public disclosure regimes
Transaction reporting
Shareholding disclosures
Short selling regime
4 Market abuse regime in Europe
The objectives of a market abuse regime
Sales and trading and the market abuse regime
MAR and MAD II
MAR: the main violations and scope
Inside information – insider dealing
Handling client information and the conundrum of insider dealing
Market manipulation
Stabilisation: legitimate form of market manipulation
Market soundings, insider lists and cleansing events
Proposed revisions to MAR
Reporting obligations under the buyback programmes for issuers
Definition of inside information
Pre-hedging
Market soundings
5 Dealing commissions and the unbundling challenge
Introduction: what are dealing commission?
Potential conflicts of interest
The US experience: the soft dollar ‘safe harbor’
Determining ‘eligible research services’
Brokerage services
Agency and riskless principal transactions
Commission sharing arrangements and third-party research
The US influence on the UK experience
The change of the tide in Europe
The corporate access debate
What is corporate access?
Corporate access prohibition in 2014
The MiFID II regime
Payment mechanism
The broker’s obligations
The conflict of law arising between the EU and US regimes
Practical guide: how does a firm price research or other services to avoid being classified as an inducement?
Pricing principles
How does a firm determine the initial price?
Life since MiFID II
6 Multilateral and bilateral trading systems
Broker crossing networks
Bilateral trading and systematic internalisation
MTFs and regulated markets
Discretion
The demise of BCNs
Pre-trade transparency obligations of different trading systems
RPW, NT and the double volume cap (DVC)
Transparency in the SI regime
Constraints on MTF and OTF operators
Constraints introduced to systematic internalisers
Interconnected Sis
Tick sizes
ESMA’s review of the trading functionality categories
7 Mandatory trading obligations
The origin of trading obligations
Shares trading obligation (STO)
Exceptional circumstances and the conundrum of third-country venue equivalence
The STO as a political weapon: the Swiss experience
The STO in the Brexit crisis
The impact of the impasse on the STO
The derivatives trading obligation
Trading obligation procedure
Conditions for third-country venue equivalence
Brexit implications for derivatives trading
8 Electronic trading
Algorithmic trading
Requirements imposed on algorithmic trading
High frequency trading
Advantages and disadvantages of HFT
Requirements imposed on HFT
Direct electronic access
DMA
Sponsored access
Smart order router
Risk control framework
Future proposals
9 Best execution
Introduction
Best execution definition: the ‘sufficient steps’ standard
Is the duty of best execution absolute?
Better or best?
When is best execution owed? The evolution of the best execution concept from equities to all asset classes
The CESR / FCA guidance on when best execution applies in bilateral trading
Challenges in the OTC markets
Challenges in applying best execution to algorithmic trading
Single venue or dark trading monitoring
Monitoring programmes
Reports to clients
RTS27 reports
RTS28 reports
What happens when best execution goes wrong?
10 The future of market structure in Europe
The UK’s approach to its perimeter
The UK Future Regulatory Framework (FRF)
The MiFID II review in Europe: revisiting what has not worked well
Suspension of regulatory obligations under Covid-19 in the EU: the ‘MiFID quick fix’
The UK quick fix
The longer-term agenda by the UK
A future of repeated cliff edges and regulatory competition
Index

Citation preview

Dealing in Securities: The Law and Regulation of Sales and Trading in Europe

Dealing in Securities: The Law and Regulation of Sales and Trading in Europe Christos Nifadopoulos

BLOOMSBURY PROFESSIONAL Bloomsbury Publishing Plc 50 Bedford Square, London, WC1B 3DP, UK 1385 Broadway, New York, NY 10018, USA 29 Earlsfort Terrace, Dublin 2, Ireland BLOOMSBURY and the Diana logo are trademarks of Bloomsbury Publishing Plc © Bloomsbury Professional Ltd 2021 All rights reserved. No part of this publication may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying, recording, or any information storage or retrieval system, without prior permission in writing from the publishers. While every care has been taken to ensure the accuracy of this work, no responsibility for loss or damage occasioned to any person acting or refraining from action as a result of any statement in it can be accepted by the authors, editors or publishers. All UK Government legislation and other public sector information used in the work is Crown Copyright ©. All House of Lords and House of Commons information used in the work is Parliamentary Copyright ©. This information is reused under the terms of the Open Government Licence v3.0 (http://www.nationalarchives.gov.uk/doc/opengovernment-licence/version/3) except where otherwise stated. All Eur-lex material used in the work is © European Union, http://eur-lex.europa.eu/, 1998–2021. British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library. ISBN: PB 978-1-52651-436-3 ePDF 978-1-52651-438-7 ePub 978-1-52651-437-0 Typeset by Evolution Design & Digital Ltd (Kent) To find out more about our authors and books visit www.bloomsburyprofessional. com. Here you will find extracts, author information, details of forthcoming events and the option to sign up for our newsletters

Preface ‘Is there anything I  could read in advance of joining?’ This is probably the question I have most commonly been asked by new-joiners who are hired into an in-house sales-and-trading legal team or being seconded by a law firm to a business environment. The answer has always been that there is no single book or article that could offer an overview. At best one could track down a collection of primary sources of legislation, industry consultations, thematic reviews by regulators or position papers prepared by trade associations – indeed several dozens of them – which one would still need to not only read but also piece together into a comprehensive narrative. It is difficult to compose from all these sources a coherent story and to identify what matters over the noise. It had become obvious to me over the years that there was a need for a book that would do all that work for the reader. My ambition has been to take a first step towards filling that gap, or at least attempt to do so. This book does not presuppose any knowledge of the fundamental principles of European law and regulation or the history of any of the key concepts. It assumes that the reader has an interest in how sales and trading works from a legal and regulatory perspective and possibly – but not necessarily – has some understanding of key concepts of English contract law. In truth, I have assumed that the reader is an interested junior compliance officer, lawyer or regulator, who is looking for an introduction into the concepts and some sense of their origination. I would not have been able to compose the book without the assistance of the many lawyers that taught me and the equally plentiful who worked with me and with whom I  have examined over time the history and the impact of the rules we were looking at. They are too many to mention, but I  would like to thank especially Chris Bates of Clifford Chance LLP for giving me my first regulatory lessons and Andrew Bagley of Goldman Sachs who taught me an enormous amount through his analytical approach to problem solving. There is an endless list of colleagues who have been a great sounding board and provided me generously with camaraderie in my professional career. In alphabetical order: Matthias Bock, Robin Brown, Sarah Brungs, Catherine Conway, Nicola Garrood, Sarah James, Michael Kent, Anna Meek, Rohan Menon, Jo Redgrave, Emma Saxton, Andrew Storey, Charlotte Stalin, Maria Troullinou, Alexandra Wessel, Richard Whiteaway, and so many more. I would particularly like to thank Monique Dixon, a trusted friend, who lent me a helping hand with diagrams in her spare time. I would have been lost without her help, a phrase I have said innumerable times in the last 12 years. Finally, I would like to thank my husband, Duncan McCall QC, for his infinite patience over the many lost weekends when I was working on this book in my ‘free’ time. All views are solely those of the author. The same is true of any errors –I pray that there are not many … The law stated is that as of 30 April 2021, except where it explicitly refers to a historic provision. Christos Nifadopoulos May 2021 v

Contents

Prefacev Table of Statutes xi Tables of European Legislation and Materials xiii Abbreviationsxix 1 Introduction

1

2 Authorising and regulating securities dealing in Europe 5 The universal public policy imperative of authorisation 5 Determining the need for authorisation 6 Deciding on whether the investment and the service are regulated 6 Providing a service out of the jurisdiction, in the jurisdiction and into the jurisdiction 8 Did the investor request the service? Solicitation and reverse solicitation8 Characteristic performance for services into the jurisdiction from abroad 9 The European dual track system 12 Harmonisation: the European single market in financial services 12 Investment Services Directive 1993 13 MiFID II intra-EU and third country provision of services 13 Providing services from one Member State to another: branch and services passports 13 Third country regime under MiFID II 15 Pan-European reverse solicitation 15 Investment Firm Review: the evolution of the third country regime 16 The approach of the single market to third countries: coexistence of national and international regimes 16 UK perimeter guidance 22 Brexit24 The impact of Brexit on authorisation regimes 25 The centrifugal force of national interests 26 Empty shells and the gravitational pull of the European Central Bank27 Annex 27 Investment services and activities in MiFID II 27 Ancillary services in MiFID II 28 Investment instruments in MiFID II 28 Client categories in MiFID II 29 3 Dealing in securities and the primary obligations Orders, RFQs and executions in the context of securities dealing Client orders and indications of interest

31 31 31 vii

Contents Simultaneous execution 32 Receipt of orders 32 Record Keeping 32 Trade booking 33 How to understand Annex I of MiFID 33 Conflicts of interest 38 Conduct of business obligations 39 Client classification 39 Communication with clients 40 Providing a written agreement 40 Assessing suitability when giving investment advice 40 Best execution 41 Inducements41 Market Transparency 42 Pre-trade transparency 42 Post-trade transparency 43 Regulatory and public disclosure regimes 43 Transaction reporting 43 Shareholding disclosures 44 Short selling regime 44 4 Market abuse regime in Europe 47 The objectives of a market abuse regime 47 Sales and trading and the market abuse regime 47 MAR and MAD II 49 MAR: the main violations and scope 49 Inside information – insider dealing 50 Handling client information and the conundrum of insider dealing 54 Market manipulation 54 Stabilisation: legitimate form of market manipulation 56 Market soundings, insider lists and cleansing events 57 Proposed revisions to MAR 57 Reporting obligations under the buyback programmes for issuers 58 Definition of inside information 58 Pre-hedging58 Market soundings 59 5 Dealing commissions and the unbundling challenge Introduction: what are dealing commission? Potential conflicts of interest The US experience: the soft dollar ‘safe harbor’ Determining ‘eligible research services’ Brokerage services Agency and riskless principal transactions Commission sharing arrangements and third-party research The US influence on the UK experience The change of the tide in Europe The corporate access debate What is corporate access? Corporate access prohibition in 2014 The MiFID II regime Payment mechanism The broker’s obligations viii

61 61 64 66 67 69 69 70 71 73 73 75 74 75 76 77

Contents The conflict of law arising between the EU and US regimes Practical guide: how does a firm price research or other services to avoid being classified as an inducement? Pricing principles How does a firm determine the initial price? Life since MiFID II

78 79 79 79 81

6 Multilateral and bilateral trading systems 83 Broker crossing networks 83 Bilateral trading and systematic internalisation 85 MTFs and regulated markets 87 Discretion88 The demise of BCNs 89 Pre-trade transparency obligations of different trading systems 90 RPW, NT and the double volume cap (DVC) 92 Transparency in the SI regime 92 Constraints on MTF and OTF operators 95 Constraints introduced to systematic internalisers 95 Interconnected Sis 95 Tick sizes 96 ESMA’s review of the trading functionality categories 96 7 Mandatory trading obligations The origin of trading obligations Shares trading obligation (STO) Exceptional circumstances and the conundrum of third-country venue equivalence The STO as a political weapon: the Swiss experience The STO in the Brexit crisis The impact of the impasse on the STO The derivatives trading obligation Trading obligation procedure Conditions for third-country venue equivalence Brexit implications for derivatives trading

99 99 101 104 105 106 107 108 108 109 109

8 Electronic trading 111 Algorithmic trading 111 Requirements imposed on algorithmic trading 113 High frequency trading 114 Advantages and disadvantages of HFT 116 Requirements imposed on HFT 117 Direct electronic access 118 DMA120 Sponsored access 121 Smart order router 121 Risk control framework 121 Future proposals 123 9 Best execution 127 Introduction127 Best execution definition: the ‘sufficient steps’ standard 128 Is the duty of best execution absolute? 129 Better or best? 130 ix

Contents When is best execution owed? The evolution of the best execution concept from equities to all asset classes The CESR / FCA guidance on when best execution applies in bilateral trading Challenges in the OTC markets Challenges in applying best execution to algorithmic trading Single venue or dark trading monitoring Monitoring programmes Reports to clients RTS27 reports RTS28 reports What happens when best execution goes wrong? 10 The future of market structure in Europe The UK’s approach to its perimeter The UK Future Regulatory Framework (FRF) The MiFID II review in Europe: revisiting what has not worked well Suspension of regulatory obligations under Covid-19 in the EU: the ‘MiFID quick fix’ The UK quick fix The longer-term agenda by the UK A future of repeated cliff edges and regulatory competition

131 132 134 135 138 139 139 140 141 142 143 143 146 147 149 150 152 152

Index155

x

Table of Statutes

[All references are to paragraph numbers] FINLAND Investment Services Act s 7.............................................. 2.34 FRANCE Decree No 2019-655..................... 2.34 Financial and Monetary Code art D.532-40.............................. 2.34 SWITZERLAND Federal Council Ordinance (30 November 2018)................... 7.19 UNITED KINGDOM Financial Services and Markets Act 2000................................ 2.36

UNITED KINGDOM – contd s 19..........................................2.36, 2.39 20(1), (1A).............................. 2.36 21............................................ 2.45 22............................................ 2.38 26, 27...................................... 2.37 28............................................ 2.37 (3)....................................... 2.36 29............................................ 2.37 30(4)....................................... 2.36 UNITED STATES Investment Advisers Act 1940...... 5.67 Securities Exchange Act 1934 s 28(e)............................5.16, 5.17, 5.18, 5.31, 5.40, 5.46

xi

Table of European Legislation and Materials

[All references are to paragraph numbers] TREATIES AND AGREEMENTS Treaty on European Union (Maastricht, 7 February 1992) [2002] OJ C325/5 (Consolidated version)......................................................................................................................... 2.18, 2.22 REGULATIONS Regulation (EU) No 236/2012 of the European Parliament and of the Council of 14 March 2012 on short selling and certain aspects of credit default swaps (Short Selling Regulation) [2012] OJ L86/1.................................................................................  2.20; 3.45, 3.46, 3.48 Regulation (EU) No 648/2012 of the European Parliament and of the Council of 4 July 2012 on OTC derivatives, central counterparties and trade repositories (European Market Infrastructure Regulation) [2012] OJ L201/1.........................................7.5, 7.28; 10.23 Regulation (EU) No 575/2013 of the European Parliament and of the Council of 26 June 2013 on prudential requirements for credit institutions and investment firms and amending Regulation (EU) No 648/2012 (Capital Requirements Regulation) [2013] OJ L176/1....................................................................................................................... 2.19 Regulation (EU) No 596/2014 of the European Parliament and of the Council of 16 April 2014 on market abuse (market abuse regulation) and repealing Directive 2003/6/EC of the European Parliament and of the Council and Commission Directives 2003/124/ EC, 2003/125/EC and 2004/72/EC (Market Abuse Regulation) [2014] OJ L 173/1...... 2.20; 4.2, 4.8, 4.9, 4.10, 4.20, 4.25, 4.28, 4.36, 4.37 Recital (33)...................................................................................................................... 4.33 art 5(4)(a)........................................................................................................................ 4.31 7................................................................................................................................. 4.11 (1)(d)........................................................................................................................ 4.38 (2)............................................................................................................................4.11, 4.20 8................................................................................................................................. 4.12 9................................................................................................................................. 4.23 (2)(a), (b).................................................................................................................. 4.22 10(1)........................................................................................................................... 4.33 11(1)........................................................................................................................... 4.33 (4)........................................................................................................................... 4.20 (6)........................................................................................................................... 4.40 12............................................................................................................................... 4.25 14............................................................................................................................... 4.10 15............................................................................................................................... 4.25 18(1)........................................................................................................................... 4.34 Regulation (EU) No 600/2014 of the European Parliament and of the Council of 15 May 2014 on markets in financial instruments and amending Regulations (EU) No 648/2012 (Markets in Financial Instruments Regulation) [2014] OJ L173/84.............. 2.19, 2.21; 6.32, 6.37, 6.48; 10.12, 10.15 Recital (6)........................................................................................................................ 6.18 (7)...................................................................................................................... 6.13, 6.16 (8)........................................................................................................................ 6.17 (9)........................................................................................................................ 6.41 (11)............................................................................................................... 7.6, 7.9, 7.11 (17)...................................................................................................................... 7.36 art 3-8.............................................................................................................................. 3.34 9................................................................................................................................. 3.34 (4)............................................................................................................................. 6.37

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Table of European Legislation and Materials Regulation (EU) No 600/2014 – contd art 9(5)(d)........................................................................................................................ 6.37 10-16.......................................................................................................................... 3.34 17............................................................................................................................... 3.34 17a.............................................................................................................................. 6.48 18............................................................................................................................... 3.34 (2)........................................................................................................................... 6.38 (3)........................................................................................................................... 6.39 (5)........................................................................................................................... 6.36 (6)........................................................................................................................... 6.37 (7)........................................................................................................................... 6.39 (10)......................................................................................................................... 6.37 19, 20......................................................................................................................... 3.34 21............................................................................................................................... 3.34 (3), (4).................................................................................................................... 10.13 23............................................................................................................ 7.6, 7.7, 7.14; 10.13 (1)........................................................................................................................... 7.7 (2)........................................................................................................................... 6.18 26............................................................................................................................... 3.40 28............................................................................................................................... 7.25 (1)........................................................................................................................... 7.29 (4)........................................................................................................................... 7.32 32............................................................................................................................... 7.28 34............................................................................................................................... 7.26 46....................................................................................................................2.27, 2.46, 2.48 47........................................................................................................... 2.27, 2.46, 2.48; 10.2 Regulation (EU) No 909/2014 of the European Parliament and of the Council of 23 July 2014 on improving securities settlement in the European Union and on central securities depositories and amending Directives 98/26/EC and 2014/65/EU and Regulation (EU) No 236/2012 (Central Securities Depository Regulation) [2014] OJ L257/1....... 2.20 Regulation (EU) No 2019/2033 of the European Parliament and of the Council of 27 November 2019 on the prudential requirements of investment firms and amending Regulations (EU) No 1093/2010, (EU) No 575/2013, (EU) No 600/2014 and (EU) No 806/2014 (Investment Firm Regulation)..................................... 2.19, 2.21, 2.31, 2.56; 6.48 Commission Delegated Regulation (EU) 2017/565 of 25 April 2016 supplementing Directive 2014/65/EU of the European Parliament and of the Council as regards organisation requirements and operating conditions for investment firms and defined terms for the purposes of that Directive [2017] OJ L87/1............................................................3.23; 6.46 art 13(1)........................................................................................................................... 5.58 18............................................................................................................................... 8.7 19............................................................................................................................... 8.16 Commission Delegated Regulation (EU) 2015/761 of 17 December 2014 supplementing Directive 2004/109/EC of the European Parliament and of the Council with regard to certain regulatory technical standards on major holdings [2014] OJ L120/2................. 3.42 Commission Delegated Regulation (EU) 2016/1052 of 8 March 2016 supplementing Regulation (EU) No 596/2014 of the European Parliament and of the Council with regard to regulatory technical standards for the conditions applicable to buy-back programmes and stabilisation measures [2016] OJ L173/34 Recital (6)........................................................................................................................ 4.31 Commission Delegated Regulation (EU) 2017/573 of 6 June 2016 supplementing Directive 2014/65/EU of the European Parliament and of the Council on markets in financial instruments with regard to regulatory technical standards on requirements to ensure fair and non-discriminatory co-location services and fee structures (RTS 10) [2017] OJ L87/145.......................................................................................................... 8.25 art 1................................................................................................................................. 8.25 (2)-(4)....................................................................................................................... 8.25 2................................................................................................................................. 8.25 Commission Delegated Regulation (EU) 2017/575 of 8 June 2016 supplementing Directive 2014/65/EU of the European Parliament and of the Council on markets in financial instruments with regard to regulatory technical standards concerning the date to be published by execution venues on the quality of execution of transactions (RTS 27) [2017] OJ L87/152.......................................................................................................... 9.36, 9.37, 9.39, 9.41, 9.43, 9.44; 10.15, 10.16, 10.19, 10.20, 10.21 Recital (7)........................................................................................................................ 9.39 art 6(f)............................................................................................................................. 9.41

xiv

Table of European Legislation and Materials Commission Delegated Regulation (EU) 2017/576 of 8 June 2016 supplementing Directive 2014/65/EU of the European Parliament and of the Council with regard to regulatory technical standards for the annual publication by investment firms of information on the identity of execution venues and on the quality of execution (RTS 28) [2017] OJ L87/166............................................................... 9.36, 9.42, 9.43, 9.44; 10.15, 10.17, 10.20 Commission Delegated Regulation (EU) 2017/578 of 13 June 2016 supplementing Directive 2014/65/EU of the European Parliament and of the Council on markets in financial instruments with regard to regulatory technical standards specifying the requirements on market making agreements and schemes (RTS 8) [2017] OJ L87/183........... 8.50 Commission Delegated Regulation (EU) 2017/584 of 14 July 2016 supplementing Directive 2014/65/EU of the European Parliament and of the Council with regard to regulatory technical standards specifying organisation requirements of trading venues (RTS 7) [2017] OJ L87/350...................................................................................................... 8.50 Commission Delegated Regulation (EU) 2017/589 of 19 July 2016 supplementing Directive 2014/65/EU of the European Parliament and of the Council with regard to regulatory technical standards specifying the organisational requirements of investment firms engaged in algorithmic trading (RTS 6) [2017] OJ L87/417.............................. 8.38, 8.39, 8.42, 8.48, 8.49, 8.50 art 5...............................................................................................................................8.39, 8.40 (4)(a), (b), (d)........................................................................................................... 8.41 6................................................................................................................................. 8.43 7................................................................................................................................. 8.41 9...............................................................................................................................8.44, 8.45 10............................................................................................................................... 8.45 21(4).........................................................................................................................8.29, 8.31 DIRECTIVES First Council Directive 73/239/EEC of 24 July 1973 on the coordination of laws, regulations and administrative provisions relating to the taking-up and pursuit of the business of direct insurance other than life assurance (Solvency Directive) [1973] OJ L228/3............................................................................................................................. 2.19 Council Directive 93/22/EEC of 10 May 1993 on investment services in the securities field (Investment Services Directive) [1993] OJ L141/27......................... 2.19, 2.21, 2.22, 2.23, 2.34 Directive 2003/6/EC of the European Parliament and of the Council of 28 January 2003 on insider dealing and market manipulation (Market Abuse Directive) [2003] OJ L96/16.2.20 Directive 2004/39/EC of the European Parliament and of the Council of 21 April 2004 on markets in financial instruments amending Council Directives 85/611/EEC and 93/6/ EEC and Directive 2000/12/EC of the European Parliament and of the Council and repealing Council Directive 93/22/EEC (MiFID) [2004] OJ L145/1............................1.9; 2.19, 2.21, 2.23, 2.24, 2.34, 2.41, 2.46; 3.6, 3.12, 3.15, 3.40; 4.8, 4.9, 4.28, 5.43; 6.5, 6.7, 6.9, 6.11, 6.17, 6.18, 6.20, 6.24, 6.26, 6.49; 7.3, 7.20; 8.46; 9.3, 9.12, 9.37; 10.2, 10.14, 10.15 art 4................................................................................................................................. 5.43 Directive 2004/109/EC of the European Parliament and of the Council of 15 December 2004 on the harmonisation of transparency requirements in relation to information about issuers whose securities are admitted to trading on a regulated market and amending Directive 2001/34/EC (Transparency Directive) [2004] OJ L390/38..........3.41, 3.42 Directive 2006/48/EC of the European Parliament and of the Council of 14 June 2006 relating to the taking up and pursuit of the business of credit institutions (Banking Consolidation Directive) [2006] OJ L177/1................................................................... 2.19 Directive 2013/36/EU of the European Parliament and of the Council of 26 June 2013 on access to the activity of credit institutions and the prudential supervision of credit institutions and investment firms, amending Directive 2002/87/EC and repealing Directives 2006/48/EC and 2006/49/EC (Capital Requirements Directive) [2013] OJ L176/338......................................................................................................................... 2.19 Directive 2014/57/EU of the European Parliament and of the Council of 16 April 2014 on criminal sanctions for market abuse (Market Abuse Directive II)..................................  4.8, 4.9 Directive 2014/65/EU of the European Parliament and of the Council of 15 May 2014 on markets in financial instruments and amending Directive 2002/92/EC and Directive 2011/61/EU (MiFID II) [2014] OJ L173/179.......................................1.11; 2.5, 2.6, 2.13, 2.19, 2.21, 2.23, 2.27, 2.28, 2.31, 2.34, 2.59, 2.60, 2.61, 2.62; 4.9, 4.37; 5.34, 5.53, 5.54, 5.55, 5.57, 5.60, 5.67, 5.68, 5.69, 5.70, 5.77; 6.5, 6.9, 6.18, 6.19, 6.22, 6.23, 6.26, 6.27, 6.36, 6.38, 6.43, 6.44, 6.45, 6.49; 7.0, 7.3, 7.16, 7.17, 7.25; 8.4, 8.6, 8.13, 8.26, 8.27, 8.32, 8.47. 8.50; 9.3, 9.28, 9.34, 9.39; 10.12, 10.13, 10.14, 10.15, 10.21

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Table of European Legislation and Materials Directive 2014/65/EU – contd Recital (62)...................................................................................................................... 8.22 (63)...................................................................................................................... 8.6 (100).................................................................................................................... 9.30 (107).................................................................................................................... 9.33 (108).................................................................................................................... 9.30 (113).................................................................................................................... 8.22 art 2................................................................................................................................. 2.41 (1)(d)........................................................................................................................ 2.6; 8.32 (e)........................................................................................................................ 8.21 (j)......................................................................................................................... 8.21 4(1)(19)...................................................................................................................... 6.10 (20)...................................................................................................................... 6.9 (21)...................................................................................................................... 6.12 (22)...................................................................................................................... 6.12 (39)...................................................................................................................... 8.4 (40)...................................................................................................................... 8.13 (41)...................................................................................................................... 8.27 10.............................................................................................................................2.34, 2.51 17.............................................................................................................................8.22, 8.44 (1)........................................................................................................................... 8.8, 8.38 (2)..................................................................................................................8.8, 8.38, 8.49 (3).........................................................................................................................8.22, 8.38 (4).........................................................................................................................8.23, 8.38 (5).......................................................................................................6.43, 6.50; 8.38, 8.49 (6)........................................................................................................................... 8.38 18(5)........................................................................................................................... 8.24 24(7)(b)...................................................................................................................... 5.55 (8)........................................................................................................................... 5.55 25(4)(a)...................................................................................................................... 7.6 27............................................................................................................................... 6.33 (1)........................................................................................................................... 9.4 (3)........................................................................................................................... 9.33 34(1), (3).................................................................................................................... 2.26 39....................................................................................................................2.28, 2.29, 2.34 42............................................................................................................................... 2.29 Title III (arts 44-56)........................................................................................................ 6.12 art 47(2)........................................................................................................................... 6.50 48.............................................................................................................................6.48; 8.24 (7)........................................................................................................................... 8.32 (8)........................................................................................................................... 8.25 Annex 1........................................................................................................................... 3.16 Section A..........................................................................................................2.59, 2.60; 3.11 para 2.........................................................................................................................3.11, 3.12 3........................................................................................................................... 3.11 Section B................................................................................................................... 2.60; 3.11 para 5........................................................................................................................... 3.11 6........................................................................................................................... 3.13 7........................................................................................................................... 3.13 Section C..................................................................................................................... 2.61 Annex 2.........................................................................................................................2.62, 3.16 Directive (EU) 2016/97 of the European Parliament and of the Council of 20 January 2016 on insurance distribution (Insurance Distribution Directive) [2016] OJ L26/19........... 2.19 Commission Delegated Directive (EU) 2017/593 of 7 April 2016 supplementing Directive 2014/65/EU of the European Parliament and of the Council with regard to safeguarding of financial instruments and funds belonging to clients, product governance obligations and the rules applicable to the provision or reception of fees, commissions or any monetary or non-monetary benefits (MiFID Delegated Directive) [2016] OJ L87/500........................................................................................................................ 5.59, 5.62 art 13(9)........................................................................................................................... 5.63 Dir (EU) 2021/338 of the European Parliament and of the Council of 16 February 2021 amending Directive 2014/65/EU as regards information requirements, product governance and position limits, and Directives 2013/36/EU and (EU) 2019/878 as regards their application to investment firms, to help the recovery from the COVID-19 crisis (MiFID Quick Fix Directive) [2021] OJ L68/14............ 10.15, 10.16, 10.18, 10.20, 10.21

xvi

Table of European Legislation and Materials DECISIONS Commission Implementing Decision (EU) 2017/2441 of 21 December 2017 on the equivalence of the legal and supervisory framework applicable to stock exchanges in Switzerland in accordance with Directive 2014/65/EU of the European Parliament and of the Council [2017] OJ L344/52...................................................................................... 7.17

xvii

List of Abbreviations

ACPR AFM AMF BaFIN BCD BCN BRRD CBI CCA CESR CNMV COBS CONSOB CRD CRR CSA CSDR CSSF DFSA DVC

ECB ECP

Autorité de contrôle prudentiel et de resolution – the French prudential and resolution authority De Autoriteit Financiële Markten – the Dutch securities regulator Autorité des marchés financiers – the French securities regulator Bundesanstalt für Finanzdienstleistungsaufsicht – the German securities and prudential regulator Banking Consolidation Directive (2000/12/EC) Broker Crossing Network Bank Recovery and Resolution Directive (2014/59/EU) Central Bank of Ireland – the main financial regulator of the Republic of Ireland Client Commission Agreement Committee of European Securities Regulators, succeeded by ESMA Comisión Nacional del Mercado de Valores – the Spanish securities regulator Conduct of Business Sourcebook, in the UK rule book Commissione Nazionale per le Società e la Borsa – the Italian securities regulator Capital Requirements Directive (2014/17/EU) Capital Requirements Regulation (EU/575/2013) Commission Sharing Agreement Central Securities Depositories Regulation (EU/909/2014) Commission de Surveillance du Secteur Financier – the securities and prudential regulator of Luxembourg Finanstilsynet or Danish Financial Supervisory Authority – the Danish securities regulator Double Volume Cap, the mechanism through which trading venues operating under the Reference Price Waiver or Negotiated Trade Waiver are restricted from using the waivers, when they or collectively their peers exceed certain volume thresholds, see Chapters 6 and 10 European Central Bank – the Central Bank of the Eurozone and the prudential regulator for systemically important credit institutions in the EU Eligible counterparty xix

List of Abbreviations EEA ELP ESMA FATF FINRA

FIX

FPO FSA

FSMA (UK) FSMA (Belgium) FX HFT IFR IOSCO ISD MAD MAD II

MAR MiFID

xx

European Economic Area, consisting of the EU, Norway, Iceland and Lichtenstein Electronic liquidity provider The European Securities and Markets Authority – the EU financial regulatory agency responsible for securities supervision, which succeeded the CESR The Financial Action Task Force – an intergovernmental organisation founded in 1989 to develop policies to combat money laundering Financial Industry Regulatory Authority, Inc – a private corporation that acts as a self-regulatory organisation for securities regulation in the US. FINRA is the successor to the NASD (National Association of Securities Dealers, Inc) The Financial Information eXchange (FIX) protocol – an open electronic communications protocol designed to standardise and streamline electronic communications in the financial services industry The Financial Services and Markets Act 2000 (Financial Promotion) Order 2005 (SI 2005/1529) Financial Services Authority – the UK regulator for financial services, supervising both in terms of conduct and prudential matters the banking, securities, asset management and insurance sectors. Succeeded by the FCA and in the majority of prudential matters by the PRA The Financial Services and Markets Act 2000 Autorité des services et marchés financiers, or the Financial Services and Markets Authority – the Belgian securities regulator Foreign exchange High frequency trading, as defined at para 8.10 et seq. Invest Firm Review Directive on the prudential supervision of investment firms (EU/2019/2034) The International Organization of Securities Commissions – an association of organisations that regulate the world’s securities and futures markets. Investment Services Directive – Council Directive on investment services in the securities field (93/22/EEC) Market Abuse Directive on insider dealing and market manipulation (2003/6/EC) – superseded by MAR and MAD II Market Abuse Directive II on criminal sanctions for market abuse (2014/57/EU) – together with MAR, it superseded MAD and sets out criminal sanctions for abuses including market manipulation, insider dealing and unlawful disclosure of inside information Market Abuse Regulation (EU/596/2014) – repealed MAD Markets in Financial Instruments Directive (2004/39/EC) – superseded by MiFIR and MiFID II

List of Abbreviations MiFID II MiFID Org Regulation MiFIR MTF OECD OTC PERG PRA

RAO RFQ RTS

RTS27 RTS28 SEC SI SOR SSR TCA TWAP VWAP

Markets in Financial Instruments Directive II  (2014/65/ EU) Commission Delegated Regulation (EU) 2017/565 of 25  April 2016 – supplements Directive 2014/65/EU (MiFID II) Markets in Financial Instruments Regulation (EU/600/2014) – amending MiFID Multilateral trading facility Organisation for Economic Co-operation and Development – an intergovernmental economic organisation with 37 member countries Over the counter – a transaction agreed on a bilateral basis between counterparties, without the involvement of a trading venue Perimeter Guidance Sourcebook in the FCA Rulebook Prudential Regulation Authority – the UK prudential regulator, within the Bank of England, responsible for the prudential supervision of banks, building societies, credit unions, insurers and major investment firms Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 (SI/2001/544) (as amended) Request for quote Regulatory technical standard, a form of delegated regulation adopted by the European Commission on the recommendation of ESMA and other supervisory authorities Commission Delegated Regulation (EU/2017/575) Commission Delegated Regulation (EU/2017/576) The US  Securities and Exchange Commission – an independent agency of the US federal government, tasked with securities markets supervision Systematic internaliser Smart order router Short Selling Regulation (EU/236/2012) Transaction costs analysis, an industry tool for best execution analysis Time weighted average price Volume weighted average price

xxi

1 Introduction

1.1 The title of this book, Dealing in Securities: The Law and Regulation of Sales and Trading in Europe, is an attempt to capture the overarching theme of the wide range of topics covered here. Perhaps the best way to comprehend the subject matter of the book is to consider the daily life of a sales and trading lawyer and compliance officer in Europe. Day-to-day, the questions that would cross one’s desk relate to the ability of a firm to service a client on the basis of the licence the firm holds, the type of trading that is allowed within specific businesses, the manners of trading that are not prohibited by market abuse, and the key conduct of business considerations when servicing clients and participating in the financial markets. By definition, sales and trading is focused on the wholesale markets and the larger clients, although all the concepts have an applicability for retail clients too. In the case of retail business, there is an additional overlay of consumer protection, which is outside the scope of this book. 1.2 The excitement of being landed with what sounds like a random collection of problems is what makes the role of a sales and trading lawyer particularly rewarding, especially in a fast-paced markets-driven environment. That is also the greatest challenge: trying to comprehend the practical implications of the law and regulation and to be quick, pragmatic and accurate in the advice given. In my experience, in both private practice and in an in-house capacity, the black letter law and regulation is hard to comprehend without understanding the workings of a broker, a dealer or an investment bank at large. This often results in bad advice, and by bad one means unusable advice. Private practice lawyers often restate the law, which, although accurate, does not advance the problem at hand further or – even better – offer a range of solutions. In-house teams often rely on external advice too heavily, or they know why an issue should be resolved with a particular outcome but cannot justify their workings readily. The most useful advice is given when the best qualities of the external advisor are met with those of an in-house practitioner. This is why law firms will often second their lawyers with clients, to give them a sense of the workings of an institution and to give them the opportunity to hone their advice by referring the black-letter rules and regulations to business practices. 1.3 This book has been approached in the way that one would approach these matters with anyone seconded to or any new-joiner in a team of lawyers or compliance officers. The book is also trying to cover most of the main topics that the author has had to delve into throughout the years, although under no circumstances could it be comprehensive – that endeavour would have been impossible. 1.4 Sometimes, the approach includes the background and history of an issue. Explaining the way in which a rule has come about, or been refined through the years, and examining the debates that were about at the time of genesis of the rule, are fundamental aspects to understanding the intention behind it and interpreting it correctly. Without understanding its genesis, its evolution and 1

1.5  Introduction why it is expressed this way, one cannot provide advice that is responsive to regulatory sensitivities and supervisory concerns. 1.5 In carving the subject matter of the book, some difficult choices had to be made: as part of offering execution services, clients’ transactions will result in securities being cleared and safeguarded by clearers and custodians respectively. As these questions are covered in Dermot Turing’s Clearing and Settlement (Bloomsbury Professional, 2021), they are not considered here. It is also the case that, when acting as a principal, firms may end up dealing with a client under an ISDA, GMSLA, GMRA or other type of standardised form of contract. These are not covered in this book, as there is a huge amount of literature providing guidance. Instead, this book is focused on the actual workings of the activity of sales and trading, not necessarily the contractual documentation that governs the trade once it is concluded. By virtue of securities regulation being decades-old and very well developed, the majority of the chapters give examples relating to securities rather than OTC contracts, although the requirements examined here are equally applicable to all financial instruments under European regulation. 1.6 Dealing in securities should therefore be construed broadly as dealing and brokering in both securities and OTC contracts. The main focus is sales and trading and the law and regulation which governs it. 1.7 The ‘in Europe’ aspect of the title has ironically become the most problematic element in recent years. The book began its life in the maelstrom of political and regulatory debates that raged in the immediate aftermath of the Brexit vote and was completed soon after the end of the Transition Period, in April 2021. In that time, the single market in financial services, which would have allowed a more-or-less uniform treatment of financial services law and regulation in the book, started unravelling. Glimpses of the divergence between the UK and its erstwhile fellow EU member states can be seen across the book, although one feels we are only at the beginning of that process. For now, the majority of UK regulation in financial services is still that inherited through the UK’s membership of the EU, and therefore one can examine most concepts with some degree of consistency and an expectation that similar concerns apply in the way that the different European regulators would approach them. Of course, Europe as a geographic concept is larger than the 27 Member States of the EU and the UK. Switzerland, for one, is an important component of the financial services ecosystem although, through its own association with the EU, some similar principles apply in its own regulatory system. The emerging markets of the Western Balkans or the ex-Soviet republics are less important for global finance, and one would expect that any further expansion of the EU may result in the superimposition of existing EU rules in these jurisdictions, much as happened with Central and Eastern European countries after the 2004 expansion of the EU. The focus has therefore remained on the UK and the EU. Where expedient, some parallels are drawn from the US, to elucidate certain rules. 1.8 Chapter 2 addresses the threshold question of the circumstances under which a broker dealer is viewed as the provider of services regulated in Europe. After looking at the reasons for which that activity needs to be authorised by supervisors and regulatory authorities, the key concepts that trigger authorisation are examined, including characteristic performance, solicitation and reverse solicitation. The application of these principles to national regimes and the European single market allows an examination of the complexity of the European landscape, but also of the optionality that is on offer. The UK’s own domestic arrangements are then examined, as well as the impact of Brexit on the 2

Introduction 1.14 respective arrangements of the UK and the EU and the supervisory expectations of key regulators. 1.9 Having established when a firm needs to be regulated, Chapter  3 gives an overview of some key obligations by which a firm has to abide. The examination of these obligations begins with an attempt to define key concepts, such as an order, a request for quote, a done trade, and the principal functions performed by employees of an investment firm engaged in brokerage services and dealing in securities. Those functions are then mapped against the key regulatory permissions included in MiFID, so that the regulatory nomenclature can be parsed into the day-to-day terms used in business circles. Following that, there is an examination of the conflicts of interest, followed by a brief description of the most important conduct of business obligations. The requirements for market transparency are then examined, as they drive the behaviour and market strategy of investment firms. The chapter concludes with an overview of regulatory and public disclosure regimes. 1.10 Chapter 4 is focused on market abuse, setting out the key objectives of the regime and the key violations that may be relevant to a sales and trading activity. Inside information and the offence of insider dealing is reviewed, together with examples of such behaviour. The offence of market manipulation and the safe harbours that would protect a firm from being sanctioned for that offence are then examined. Finally, possible revisions of the regime are examined, as they may come to fruition in the coming years. 1.11 In Chapter 5, the way in which brokers are paid comes under scrutiny, together with an assessment of the potential conflicts of interest arising from certain arrangements. This chapter looks at the unbundling debate and the use of dealing commissions, explaining their role in the remuneration of brokers and in the receipt of services by their clients, the portfolio managers. An examination of the US parallels here helps elucidate how other authorities have sought to manage these conflicts. This then leads to the examination of the hard unbundling pursued by the EU during the implementation of MiFID II and the way that the industry has implemented these MiFID II requirements. 1.12 Having looked at the way in which brokers are paid for execution and research services, Chapter 6 focuses on the way in which brokers can transact with their clients and the confines imposed by regulation in different styles of trading. To explain these constraints, the concepts of multilateral and bilateral trading are introduced. We trace briefly the history of the roots of broker crossing networks, the needs that they served, and how they fell out of favour. Then, the different modes of trading and the different venues are examined. We also review the limitations imposed on systematic internalisers and operators of MTF and OTFs, prior to looking at the potential review of some of these categories by ESMA. 1.13 Having looked at the different venues, Chapter 7 focused on the thorny subject of mandatory trading obligations, both for shares and derivatives. Then we look at the politicised role that these obligations played during the Brexit debate and in the Swiss-EU bilateral relationship. 1.14 Chapter 8 seeks to address the special considerations applicable to firms that conduct electronic trading. After the principal concepts are introduced, there is an exposition of the special requirements applicable to algorithmic trading, high-frequency trading and market making. We then look at the issues arising from direct electronic access as opposed to smart order routing. Finally, the 3

1.15  Introduction expectations surrounding a risk control framework are reviewed, together with future proposals by ESMA to relook at some of the regulatory categories. 1.15 Chapter 9 attempts a deep dive into best execution as a pivotal conduct of business obligation. We look at the sufficient steps standard, the conditions under which best execution is owed, and the more problematic areas of application. On a more practical level, there is an overview of what the monitoring programmes need to achieve, as well as the key reporting obligations introduced by MiFID II which are already under review. We finally look at the key question of what happens when best execution goes wrong. 1.16 Finally, Chapter 10 looks towards the future and seeks to discern the main trends in sales and trading law and regulation. Using the main concepts introduced in the earlier chapters, it attempts an overview of recent developments that may give a sense of direction, especially in the post-Brexit era, for both sides of the Channel.

4

2 Authorising and regulating securities dealing in Europe

This chapter will provide an overview of the following topics: • The imperative for governments to regulate financial services and, in particular, securities transactions. • How governments have sought to define the perimeter, ie what is within the policy boundaries and geographical boundaries of regulation. • The formation of the European single market in financial services. • The approach to third country access by the Member States of the EU. • The Overseas Persons Exclusion in the UK and the UK perimeter. • The impact of Brexit on third country access in the EU and the UK.

THE UNIVERSAL PUBLIC POLICY IMPERATIVE OF AUTHORISATION 2.1 Ever since the emergence of financial bubbles, such as the South Sea Company bubble in 1711, governments have increasingly realised that the general public’s access to financial products can lead to prosperity as well as ruin, in equal measure. There is a very real need for a capitalist economy to be open to investing by all who can. This openness not only adds to the prospect of widespread prosperity, but also provides legitimacy to the economic system. Imagine a world where a person is not permitted to invest at all, but another section of the population has privileged access to investing. In an ideal universe, where all financial risks were equal and all individuals had the same sophistication, risk tolerance and financial means, a government would be able to allow everyone access to all investment products in equal measure. In the real world, investments come with different levels of risk, and several of them can result in wiping out all economic resources of the investors, leaving them in complete destitution and a burden to the state. 2.2 Additionally, a seasoned investor with experience in the markets would have the ability to assess the level of investment and timing of their entering and exiting an investment more competently than someone who is delving into the financial markets for the first time. Governments, therefore, have to take a measured approach between allowing access to investment products and protecting those without sufficient knowledge or of vulnerable financial means. A further consideration for governments is the presence of unscrupulous providers of financial services, who either mislead the public or mismanage the public’s investments. 5

2.3  Authorising and regulating securities dealing in Europe 2.3 For these reasons, there are regimes in all developed and emerging economies dictating: • what type of activities and products require authorisation by the state and the maintenance of a licence (resulting in ongoing supervision by competent authorities, ie regulators); • the conditions that need to be fulfilled by a licensed provider, both in terms of resources and organisation (prudential supervision) as well as in the process of providing the service (conduct supervision); • limitations on the licence provided (for instance, in respect of the categories of clients that the service provider is allowed to access); • penalties, often criminal, for engaging in a regulated activity without a licence, as well as other sanctions against violating the regulatory standards applying to the activity; and • conditions under which a regulated service could be provided without a licence in the jurisdiction.

DETERMINING THE NEED FOR AUTHORISATION 2.4 The conditions for providing the services into the jurisdiction legitimately without a licence are often nebulous, and relying on them entails some risk. It is often the case that legal advisors would seek to arrive at a conclusion that the service is not being provided in the jurisdiction by looking at a series of tests. An example of the decision tree that could be used in most cases (with some regional variation) to arrive at such a conclusion is set out at figure 2.1 below.

Deciding on whether the investment and the service are regulated 2.5 Let us examine first, by way of example, the entering into an interest rate swap between a US bank and a client, a corporation domiciled in Germany. The relevant jurisdiction for these purposes is Germany, as this is where the client is domiciled. There is a separate question as to the kind of licence that the bank would require in the US, but this is not being considered here. The first question that one has to consider is whether interest rate swaps are a regulated financial instrument in Germany (in other words, an investment that is in scope for regulatory oversight). In this case, interest rate swaps are regulated, because they are required to be so by MiFID II. Therefore their status is the same across the EU. However, if the investment in the example were spot FX, the transaction may not have been subject to authorisation, as spot FX is not uniformly regulated in the EU (other than in some jurisdictions). 2.6 The next question is whether the activity relating to the instrument is regulated. Entering into an interest rate swap would be deemed ‘dealing on own account’ in that instrument, as both parties enter for themselves into the transaction as principals (ie not on behalf of someone else) and the transaction impacts their own capital. ‘Dealing on own account’ is an investment service under MiFID II and requires the relevant entity to have a licence. So the first thorny question arises as to whether the corporation itself, as well as the bank, requires authorisation. At first blush, the answer should be positive. However, one 6

Determining the need for authorisation 2.6

Decision tree on need for authorisation Is the investment a type regulated in any way in the jurisdiction of the investor?

No

Yes Is the service in respect of regulated in the jurisdiction of the investor?

No

Yes Did the investor request the service on a one-off basis without any solicitation from the provider?

Yes

No Is the activity performed in the jurisdiction (characteristic performance)?

No

Yes

Activity requires authorisation

Activity does not require authorisation

Figure 2.1  Decision tree on need for authorisation

has to look at the characteristics of each of their behaviour. The bank’s purpose is to hold itself out as a service provider and financial counterparty to its client base. By contrast, the corporation’s primary purpose is to do whatever it is in the business of doing (for example, manufacturing cars). It is not holding itself out as a financial counterparty by way of business, and its entering into the transaction is incidental to the main purpose of its existence. In addition, the frequency with which a corporation would be entering into interest rate swaps would be dictated by its other business needs and is unlikely to be significant, especially compared with the activities of a financial institution. We are therefore venturing into the complex question of overall conduct, which consists of holding oneself out as a provider, performing the activity frequently or having that activity as its main business or source of income. On that basis, the bank would be squarely within the scope of the regulatory regime, whereas the corporation would not. In addition, 7

2.7  Authorising and regulating securities dealing in Europe MiFID II has sought to take out of the scope of authorisation entities that deal on own account in interest rate swaps and other instruments, under article 2(1)(d), unless they are market makers or dealing on own account when executing client orders. This in itself relies on an analysis of conduct, which means looking at the frequency of transactions and the relationship between the two parties, and supports the conclusion that the bank would, in principle, require authorisation (as it is executing a client order), whereas the corporation would not.

Providing a service out of the jurisdiction, in the jurisdiction and into the jurisdiction 2.7 Now that it is established that the US bank alone would potentially require a licence in Germany, the question is whether the service itself was actually provided in Germany or not. There are three possibilities in the provision of any regulated service: (1) The service is being provided in the jurisdiction. A clear example of that would be a German investment firm offering the service to a German client. In that case, there would be nothing further to examine in the analysis, as the German perimeter would be the only relevant consideration. (2) The service is being provided into the jurisdiction from abroad. In such circumstances, it is acknowledged by the authorities that the service provider is located outside the jurisdiction but the service requires the meaningful engagement of the client and therefore brings into scope local rules and regulations. In such cases, there would be a prima facie need to be authorised, unless it can be argued that the service was provided at the request of the client (see para 2.11 below). (3) The service is actually provided outside the territory of Germany and therefore not subject to authorisation requirements in Germany. This is a difficult argument to run, but one that may be possible for ‘passive services’, such as stand-alone custody services, where the service does not require the ongoing engagement of the client. The idea that the service is provided outside the jurisdiction may be further supported by the fact that the client is not targeted by the firm (see paras 2.9–2.10 below) and that the formalities of the service are all concluded overseas (see para 2.12 onwards below). 2.8 Many jurisdictions have provided guidance in terms of when their ‘regulatory perimeter’ is crossed, ie when something is both geographically and legally within the remit of the domestic regulator. There will be an opportunity to delve into the details of the UK perimeter in the next section. But let us first examine the elements which are usually engaged in the analysis of the perimeter, with different emphasis given in various jurisdictions, the main ones being solicitation and characteristic performance.

Did the investor request the service? Solicitation and reverse solicitation 2.9 Solicitation looks at the difficult issue of the initiation of the interaction between service provider and client. It is often the case that there is no clear time or point in the interaction when an idea for a trade is formed. For instance, 8

Determining the need for authorisation 2.12 representatives of a bank and of a corporation may be discussing the current economic climate at the sidebar of a conference and, together, start considering some possible transactions between them. It is therefore very hard to establish which of the two parties initiated a transaction. However, if a firm has targeted a prospective client with a specific service or a specific transaction, and has sought to engage the client in the prospect, then it would be viewed as soliciting that client. Obvious cases of solicitation would include advertising campaigns, systematic cold calling of clients, and the use of the client’s local language in promotional materials. 2.10 Solicitation is examined on a transaction-by-transaction basis or on a relationship basis, depending on the jurisdiction. In the regimes that consider solicitation on a relationship basis, if the overall relationship is solicited by a firm and that firm were to enter into a transaction subsequently on the initiative of the client, this latter transaction would not change the analysis of the overall service, as it is already established that the genesis of the relationship was through solicitation. By contrast, if a jurisdiction follows the analysis on a transaction-bytransaction basis, each set of facts pertaining to a single transaction is examined as if that were the entirety of the interaction between the two parties. Generally, if a firm is viewed as soliciting business in a jurisdiction, it would in principle trigger an authorisation requirement. 2.11 Reverse solicitation is the flipside of the same coin as solicitation. If the client has initiated the provision of services through a request to the service provider, this should enable the service provider to give access to these services to the client. The principle of reverse solicitation is often sought to be relied on only in the case of a one-off transaction. The evidential burden imposed on a firm seeking to rely on reverse solicitation is significant and often results in oxymorons. A firm is required to maintain records of the client’s first approach to the firm and their request for services. In truth, an informal approach to a firm is unlikely to be recorded in a permanent medium and with the formalities required by regulators. It is often the outcome of a conversation at a meeting on a different topic, and it is unlikely that the participants would keep a conclusive note that could be relied on. To minimise the legal and regulatory risk, firms would normally seek to obtain from clients a written statement that they requested the service. They would therefore engage their Legal and Compliance departments in approving a statement which is then put forward by their sales force to the client for signing. It is possible to see that the engagement of the firm’s operations to obtain such a statement could itself be viewed by a regulator as solicitation, which would render the reverse solicitation argument invalid. Even if it were possible to satisfy the requirements easily, one would struggle to construct a scalable business with such complicated evidential requirements. Reverse solicitation is therefore a useful exception, but one which is rarely relied on.

Characteristic performance for services into the jurisdiction from abroad 2.12 In some jurisdictions, the domestic regulatory regimes give greater emphasis to characteristic performance over solicitation in the determination of whether their regulatory perimeter is crossed, when providing services into the jurisdiction. Characteristic performance is difficult to define, but normally looks at what kind of conduct the services provider is engaged in and whether that requires the assistance of the client in the jurisdiction. There are numerous 9

2.13  Authorising and regulating securities dealing in Europe indicia, but no single one offers a decisive outcome. They have to be considered in the round to reach a balanced view. Such indicia are: • The identity of the entity/person who has signed the financial agreement for entering into an investment or procuring an investment service. If the agreement was signed by an officer of the client (rather than an agent or investment advisor acting on their behalf in another country), that would tend to engage the client’s jurisdiction. • The location where the financial agreement was signed. If the client executed the agreement by means of an officer visiting the offices of the investment firm, that could point to the service being provided in the jurisdiction of the investment firm and not in the jurisdiction of the client. • Any actions that the client is required to take in respect of the investment product, or the investment service, in the course of its life. For instance, the interest rate swap in this scenario may require certain margin calls to be made by the investment firm in the life of the trade. If that necessitates the investment firm to be in continuous contact with the client directly (rather than with the client’s agent or investment advisor in a different jurisdiction), this would add to the evidential proof that the service is provided into the jurisdiction of the client. • The location of the investment. The more unavailable that investment is in the jurisdiction of the client, the stronger the argument that the service is not provided in the jurisdiction of the client. This may be strange in the context of the interest rate swap in the example with the German corporation, but it would not be difficult to understand in the context of US Treasuries (ie government bonds issued by the US). These investments exist in dematerialised form (ie  as a book entry) in the US settlement system and are instruments governed by US law. They therefore have a legal presence outside Germany. A  more pronounced case could be an investment that is particularly inaccessible in the international markets and is hard to transfer freely between countries, such as a physically settled commodity option over coal in Colombia. • The presence of certain events in the lifecycle of the trade that require the client to take specific action, such as decisions to extend, amend or vary the terms of the investment. 2.13 A regime that had historically followed the characteristic performance approach is Luxembourg. Until recently, most international firms relied on the circular produced by the CSSF (Circular 11/515) referring to authorisation requirements in relation to services provided to clients in Luxembourg, which allowed financial services to be provided to clients on the basis of the fact that the recipients of the services (such as managed accounts) were passively receiving these services and the conduct was primarily conducted outside Luxembourg. In 2019, the Luxembourg authorities changed their guidance to align themselves with MiFID II and ESMA’s interpretation of reverse solicitation (see para 2.30 below), requiring any entity providing services to clients in Luxembourg from an overseas location to have a licence. The new requirements were included in the guidance published by the CSSF in Circular 19/716 on 10 April 2019 (https://www.cssf.lu/wp-content/uploads/cssf19_716eng_01072020.pdf [accessed 6 August 2021]). The test is based on regular provision of services to clients based in Luxembourg. In other words, the existence of these clients could in itself trigger the requirement to be authorised in Luxembourg, irrespective of the location of the performance of the service. However, the 10

Determining the need for authorisation 2.14 CSSF maintained the characteristic performance test for banking services, such as lending, deposit taking and stand-alone custody services. Subsequently, at the end of 2020, Luxembourg revised its approach yet again, engaging a test of characteristic performance for both banking and investment services in respect of all jurisdictions for which it has not provided an equivalence assessment and therefore licences would not be forthcoming. It expects, however, that entities from jurisdictions that it has assessed as equivalent would either go down the characteristic performance route or apply for a licence to the extent that they risk actively engaging with local Luxembourg clients. 2.14 Characteristic performance is a concept that, even if not often expressly endorsed by regulators in many jurisdictions, continues to have a central place in the analysis of whether the rules of a jurisdiction are engaged. A prime example of this is the provision of custody services in international finance. An investor who buys shares in companies around the world requires the services of custody (ie safekeeping of these shares) in any jurisdiction where they are legally created. The investor will therefore have a direct or indirect interest in a local Central Securities Depositary in the jurisdiction where the shares are created. To be able to do that, the investor has to rely on the services of a series of custodians, one that is licensed to operate in the client’s jurisdiction, which in turn then relies on the services of another custodian in the jurisdiction where the shares are legally present. Without acknowledgment of characteristic performance in these cases, it would be impossible for international finance to operate, as investors would not be able to hold assets other than in their jurisdiction.

Figure 2.2  Decision factors on the provision of financial services and their authorisation

11

2.15  Authorising and regulating securities dealing in Europe 2.15 In summary, there are several factors in the process of deciding whether the service is regulated and then, once the conditions are satisfied, there are ways in which these services can be provided on the basis of arrangements represented by the petals in the bottom half of figure 2.2 above. 2.16 Having examined the main parameters that would normally apply in principle in various jurisdictions, with a few examples, we will turn to the European landscape and to the specific application of these requirements in the EU, its Member States and the UK.

THE EUROPEAN DUAL TRACK SYSTEM 2.17 The European landscape regarding authorisation of financial services is marked by two processes: harmonisation through EU legislation, and diversification through domestic legislation. The pan-European regime governs the provision of services within a Member State, cross-border within the EU (from one Member State to another), as well as including provisions regarding incoming services from outside the EU. In most European countries, there is an additional layer of legislation to be examined (ie a domestic framework), which exists in parallel with the pan-European framework and may provide additional inroads for the provision of services from outside the EU. Understandably, later entrants to the EU, consisting mostly of Eastern European countries, did not have a domestic regime that pre-existed their admission to the EU, and so they rely now exclusively on the EU framework.

Harmonisation: the European single market in financial services 2.18 The single market in financial services is based on one of the four fundamental principles of the Common Market, a concept which was intended to remove national boundaries in the economic development of the European Economic Community (as the European Union was called from 1957 until the Maastricht Treaty of 1993). The four fundamental principles are: •

freedom of establishment and provision of services;

•

freedom of movement of capital;

•

freedom of movement of labour; and

•

freedom of movement of goods.

2.19 The first of these freedoms is the foundation of the single market in financial services, as it allows the creation of a uniform framework across the EU within which firms can operate. Within that framework, the three main financial services industries (ie banking, insurance and investment services) all received separate detailed treatment in a series of Directives and Regulations made by the EU: (1) For banking: the Banking Consolidation Directive (BCD); the Capital Requirements Directive (CRD), now in its fifth iteration; and the Capital Requirements Regulation (CRR), now in its second iteration. (2) 12

For insurance: the Solvency Directive, now in its second iteration; and the Insurance Distribution Directive.

The European dual track system 2.26 (3) For investment services: the Investment Services Directive (ISD), which was superseded by the Markets in Financial Instruments Directive (MiFID), now in its second iteration; the Markets in Financial Instruments Regulation (MiFIR); and the Investment Firm Regulation (IFR). 2.20 There are numerous other Directives and Regulations that we will touch on in different parts of this book, such as the Market Abuse Directive (MAD) and Market Abuse Regulation (MAR), the Short Selling Regulation (SSR) and the Central Securities Depository Regulation (CSDR), amongst others. 2.21 For the purposes of authorisation and regulation of activity that is related to securities trading in Europe, the main focus of this chapter will be on the third category of legal instruments (ie the ISD, MiFID, MiFIR and IFR).

Investment Services Directive 1993 2.22 The first legal instrument that established an incontrovertible right for financial services companies to provide services across the EU, without additional obstacles, was the Investment Services Directive 1993 (Council Directive 93/22/ EEC), which was legislated soon after the Maastricht Treaty (agreed in 1992 and entered into force on 1 November 1993). The ISD established the process of providing services and establishment of branches (see para 2.26 below).

MiFID II intra-EU and third country provision of services 2.23 MiFID, having superseded the ISD, provided a more comprehensive framework for services provided within the EU by creating an extensive conduct of business framework, with which firms have to comply. The fundamental principles for the provision of services in the Union are further elaborated in MiFID and, in particular, in MiFID II. In addition, MiFID II sets out an extensive process for recognising a third country as an eligible location from which an investment firm can provide services into the EU. 2.24 To establish which services and activities are relevant for this harmonised treatment by the EU single market, MiFID, in both iterations, sets out a list of: (i) investment services and activities; (ii) ancillary services (provided in connection with (i)); and (iii) investment instruments, meaning types of investments for which (i) and (ii) are provided. 2.25 The list of these services, activities and financial instruments is set out in para  2.59 below. Several of the provisions relating to third country access are also limited only to specific categories of clients (hence the criteria for categorising clients) are set out in para 2.62 below.

Providing services from one Member State to another: branch and services passports 2.26 The main objective of the creation of a single market in financial services was to enable companies located in any Member State of the EU to provide services across the entire EU without another Member State imposing 13

2.26  Authorising and regulating securities dealing in Europe obstacles that would disadvantage that company compared to any domestic providers. The services provided by a firm out of the Member State where it is domiciled are called ‘outgoing services’. From the perspective of the Member State where the services are received (ie  the location of the client), they are called ‘incoming services’. The provision of services may take place in two different ways: purely on a cross-border basis, without the firm setting up any establishment in the Member State of the incoming services; or the firm that is providing outgoing services from one Member State could set up an incoming services branch, by setting up an office in the Member State where the services are intended to be provided. The former is called the ‘services passport’, whereas the latter is called the ‘branch passport’. If a Member State regulator regulates the head office of a firm, it would normally display on its public authorisation register that the firm headquartered in its jurisdiction has a series of outgoing services passports and would name the other Member States for which the firm holds this passport, as well as displaying details of the licensed activities entailed in these passports. If the firm has established branches in other Member States, it would also name those outgoing branch passports. The regulator of the Member State where the services are received or where the branch is established would display on its public register the name of the firm as an ‘incoming services’ firm or as an ‘incoming branch’ of an EU firm respectively. Firms usually notify their domestic regulator as a matter of course that they would like to provide their services across the EU, so all EU regulators are notified of incoming services. This helps to protect firms against the risk of breaches of licensing restrictions, without imposing an additional supervision burden on them, as their domestic regulator remains responsible for all their activity and conduct, including their outgoing services. The situation is somewhat different for a branch, as a branch requires a de facto establishment in the jurisdiction of its location, and the local regulator does have supervision of the conduct of the branch in its jurisdiction. Whether a firm utilises the services passport or branch passport is a question of fact. It depends on whether the company has actually located personnel in the incoming jurisdiction for a long enough period to create a permanent establishment under local corporate and tax rules. These local establishment rules vary from Member State to Member State. However, if a firm locates personnel on the ground in a Member State for more than 30 consecutive days, there is a risk in most Member States of creating a branch. That risk becomes higher the longer the duration and is a near-certainty at approximately three months. Once a firm has created a corporate branch in that jurisdiction, the branch is required to be authorised in order to be operational. The consequences of operating a branch without a regulatory licence can be severe and, in some jurisdictions, could entail criminal sanctions. If, on the other hand, a firm conducts business with a client located in other Member States entirely remotely from its hub, there is no requirement to have a branch passport, and the firm can rely on the outgoing services passport instead. This is also true if representatives of the firm travel irregularly to the jurisdiction of the client for meetings without active financial promotion campaigns on the ground. If a firm decides to apply for the passport, it can do so on the basis of an application to its domestic regulator (where it is headquartered), called the ‘home state regulator’. In the case of outgoing services, the application is notified by the home state regulator within a month of receiving it from the firm to the regulator where the clients will be receiving the incoming service (Article 34(3) MiFID 14

The European dual track system 2.29 II). For incoming services, the notifications are automatically accepted without objections, as the regulators of the incoming services cannot interfere with the fundamental treaty right of a firm to be free to provide services (Article 34(1) MiFID II). In the case of incoming branches, the home state regulator has three months within which it can examine the application and may provide feedback or decline the application. Once this stage is completed, if the home state regulator has no objections, it forwards the application to the ‘host state regulator’. The host state has two months to raise objections or actively approve. If no objections are raised, the branch is able to operate by the lapse of the twomonth period, even if no formal approval has been received.

Third country regime under MiFID II 2.27 MiFID II sets out for the first time a regime under which a firm established in a jurisdiction outside the EU can benefit from a passport to provide services across the EU without establishing a presence. The relevant provisions can be found in Article 46 MiFIR. The way that this is achieved is predicated on an equivalence decision by the European Commission based on an assessment of a third country on the basis of Article 47 MiFIR. The EU would require a cooperation agreement in addition to assessing the jurisdiction equivalent. The firm should be assessed to be subject to equivalent supervision in its home state. To this date, no jurisdiction has been assessed to be equivalent by the European Commission. The creation of the equivalence regime was viewed as an important step for safeguarding options for the UK following Brexit. 2.28 In addition, the MiFID II third country regime allows the provision of services through a branch in respect of both retail and professional clients, if the jurisdiction of the firm has been assessed to qualify for such treatment by the relevant Member State. Such branch can be established in the EU under Article 39 MiFID II. The firm must be properly authorised in its own jurisdiction for the relevant activity, the branch needs to have sufficient ‘capital’ (normally understood in this context as operational reserves), and a cooperation agreement must be established between the two countries. The firm will be required to participate in the investor compensation scheme of the Member State where the branch is located. This is a very important provision which, following the transposition of MiFID II, has opened the road for third country firms establishing a branch for securities services, even in jurisdictions where this had not been possible before, notably in jurisdictions such as Italy, France, Spain and Sweden.

Pan-European reverse solicitation 2.29 According to Article 42 MiFID II, where a retail client or professional client established or situated in the EU initiates, at its own exclusive initiative, the provision of an investment service or activity by a third country firm, the third country firm is not subject to the requirements under Article  39 MiFID II, which would normally require the establishment of a branch in the EU. This provision enshrines the principle of reverse solicitation in European legislation in a way that can be relied on coherently across the EU. It was a significant step in allowing firms to rely on a concept which had not been previously accepted in every EU Member State. ESMA decided to clarify further the concept in a series of guidance notes published in the context of the implementation of MiFID II. 15

2.30  Authorising and regulating securities dealing in Europe ESMA decided that, if an agent is engaged in the jurisdiction for the purposes of solicitation, reverse solicitation cannot be relied on. ESMA is of the view that every communication means used (such as press releases, advertising on the internet, or using brochures, phone calls or face-to-face meetings) should be considered to determine if the client or potential client has been subject to any solicitation, promotion or advertising in the EU regarding the firm’s investment services and activities in respect of financial instruments. 2.30 In addition, ESMA clarified that reverse solicitation is subject to a significant evidential burden and is assessed on a case-by-case basis. The presence of legal documentation purporting to disclaim solicitation does not help a firm to demonstrate that it has relied on reverse solicitation. Therefore, when providing a one-off investment service to a client, the third country firm may not sell to that client (without establishing a branch, if so provided for by national law) a product or service from the same category unless requested to do so by the client at its own exclusive initiative and only at the time the client asks for an investment product or service. In other words, everything is assessed on a transaction-by-transaction basis or service-by-service basis, which means that the concept of reverse solicitation is construed narrowly by ESMA (www.esma. europa.eu/sites/default/files/library/esma35-43-349_mifid_ii_qas_on_investor_ protection_topics.pdf [accessed 6 August 2021]).

Investment Firm Review: the evolution of the third country regime 2.31 The Investment Firm Review was passed in 2019 as a means of rectifying various issues that the European co-legislators did not believe had been addressed adequately in MiFID II. It is a peculiar mixture of market structure provisions as well as prudential requirements (extending banking-style prudential standards to systemically important investment firms). It also includes an amendment to the third-country firm provisions of MiFID II, which were hotly contested at the time of its implementation. The Investment Firm Review requires firms which come from a third country benefitting from an equivalence determination to subject themselves to European supervisory scrutiny if their services are systemically important to the EU. The IFR was amended in that way, with one eye on Brexit and the potential that certain UK firms may have access to the EU, if the UK is declared equivalent by the European Commission in the post-Brexit landscape. It mirrors similar supervisory requirements introduced in respect of third country clearing houses benefitting from an equivalence determination. 2.32 On a positive note, it also enhances the ability of investment firms to provide services across the EU once they have established a branch from a third country, providing services to both retail and professional clients. It therefore allows for comprehensive access, at the price of more scrutiny and intense supervision.

The approach of the single market to third countries: coexistence of national and international regimes 2.33 The creation of the single market in financial services necessitated the establishment of a common understanding for the two key elements determining: 16

The European dual track system 2.34 • • •

whether services are provided in the EU; any uniform caveats for when services can be offered without triggering licensing restrictions, such as reverse solicitation; and the process through which pan-European access can be granted to a firm from outside the EU (‘a third country firm’), as well as the conditions for its operation in the EU.

2.34 However, the harmonisation of such rules, that took place with the establishment of the ISD and its successors, took the form of a Directive that required implementation into local legislation, but did not try to achieve ‘maximum harmonisation’ between the regimes of each Member State. It therefore allowed each Member State the freedom to continue with its own arrangements which could co-exist side-by-side with those of the EU. In reality, the majority of the founding members of the EU had their own domestic arrangements in place, which provided for the possibility of access to their own jurisdiction from a third country. These arrangements are still in place today. A summary of these arrangements is set out below: (a) Belgium: There is an exemption that allows the provision of investment services on a cross-border basis to Belgian clients that are not retail or opted-up professionals, subject to prior notification to the Belgian regulator (Financial Services Markets Authority). The ability to offer services on a cross-border basis is predicated on having no presence in the jurisdiction and on accessing the sophisticated client base only, that could be classified as per se professional or eligible counterparties. The activities for which the cross-border exemption may be granted are the same activities as in MiFID. There is no restriction as to which country the firm may be based in. However, there are requirements that the jurisdiction of the relevant firm is a member of the OECD, has a cooperation agreement with the Belgian regulator (at least through the IOSCO framework), and that it has in place anti-money laundering legislation that meets the expectation of the FSMA. (b) Denmark: Licensing requirements are triggered in Denmark on the basis of the characteristic performance test. The DFSA has provided some guidance as to the activities that are not considered carried out in Denmark in accordance with the characteristic performance test in a ruling of 2 January 2006: this ruling related to securities lending where the services were performed towards only one Danish financial institution (bank), the securities were kept outside Denmark, and all clearing and settlement was carried out outside Denmark. When MiFID II was implemented in Denmark, the Danish implementation allowed the provision of pure cross-border services subject to the authorisation of the Danish FSA. Absent a decision by the European Commission on equivalence of a third country, the Danish authorities have retained the ability to deem a third country firm as eligible for the provision of services into their jurisdiction. The requirements relate to information exchange between the Danish FSA and the relevant competent authority, which may be based on the IOSCO memorandum of understanding. Provision of services on a crossborder basis can be directed only to per se professionals and eligible counterparties. (c) Ireland: Ireland has historically had a pragmatic approach to provision of services from overseas jurisdictions; the outcome of this approach is that the Irish regime is as open as the UK regime of the Overseas Persons 17

2.34  Authorising and regulating securities dealing in Europe Exclusion. The Irish regime does not seek to authorise activities carried out outside the Republic of Ireland, without a presence in the jurisdiction, if the services are MiFID services and they are provided to per se professional clients and eligible counterparties. The Irish exemption, which applies a characteristic performance test to arrive at the conclusion that no authorisation is needed, was amended after the implementation of MiFID II to align itself with MiFID services and activities as well as MiFID client categorisation (see 2.62). It is included in the Irish Regulation implementing MiFID and has the following requirements: •

the Third Country Firm’s head or registered office must be in a nonEEA member state and it must not have a branch in Ireland;

•

the Third Country Firm must be subject to authorisation and supervision in the third country in which it is established, and the relevant competent authority must pay due regard to any recommendations of the Financial Action Task Force (FATF) in the context of anti-money laundering and countering the financing of terrorism; and

•

co-operation arrangements must be in place between the Central Bank of Ireland (CBI) and the competent authorities of the third country that include provisions regulating the exchange of information for the purpose of preserving the integrity of the market and protecting investors.

(d) Italy: Licensing can be triggered in Italy by a number of factors, one of which is solicitation. If the services are provided on a strictly remote basis and without solicitation of client business, then the licensing requirement may not be triggered. However, it is irrelevant whether the solicitation is conducted directly by the firm providing the services or an affiliate of that entity which happens to be authorised locally. The reason for that is that the Italian regime recognises the concept of partial performance – ie where a local entity promotes the services of an overseas affiliate, the regulators may consider that the entire service is being provided by the affiliate in Italy, thereby triggering licensing requirements. In greater detail, Communications no DI/99091709 of 15-12-1999 and no DI/99052838 of 7-7-1999 set out a list of indicators which the Commissione Nazionale per le Società e la Borsa (CONSOB) uses to determine whether services provided via a website (or an online platform) are carried out in Italy. CONSOB would take into consideration whether the website is in Italian or includes such an option, whether it is advertised on popular Italian websites, or whether the platform contains a specific section focusing on the Italian market. Solicitation is considered on a transaction-bytransaction basis. Italy has had a third-country firm regime for several decades, but that regime focused on banking services provided from a third country bank through an Italian branch. Several major institutions, especially from the United States, took advantage of such arrangements. More recently (2018), and in the context of its MiFID II implementation, Italy went beyond its banking third country regime and introduced a similar regime for third country investment services. Non-EEA entities can seek a cross-border licence from CONSOB. However, obtaining such licence is difficult as some of the requirements include that CONSOB would be satisfied with the level of supervision of the non-EEA firm in its home state. CONSOB would 18

The European dual track system 2.34 also only grant this licence if it has an agreement in place for exchange of information with the home state regulator of the non-EEA entity. (e) Finland: Finland had a cross-border licence prior to the implementation of MiFID II, available to third-country firms, although it appears that there had been no firms that had sought that authorisation. Upon introducing legislation for the implementation of MiFID II, the Finnish legislators decided that they did not need to exercise the option available under MiFID II to have a domestic regime available for cross-border services from third country firms, above and beyond the European Commission process for equivalence assessment. This approach essentially closed down the option that would have been available to UK firms to access the Finnish market post-Brexit, absent an equivalence decision by the European Commission. However, after a period of deliberation, the Finnish legislators decided to amend the MiFID implementing Act to reinstate the Finnish cross-border licence, under Chapter  5, section 7 of the Finnish Investment Services Act. This licence permits the provision of investment services on a crossborder basis to Finnish clients (per se professionals and ECPs), subject to authorisation by the Finnish regulator. (f) France: Over many years, there was a debate in France whether bilateral trading by French institutions with non-EU counterparties should be regulated in France. Eventually, on 12  February 2019, the Autorité des Marchés Financiers (AFM) and the Autorité de contrôle prudentiel et de résolution (ACPR) confirmed in a letter to the industry that they were of the view that such activity constituted inter-dealer activity that was not subject to their supervision. This inter-dealer exemption was then put on firmer ground, by being introduced in legislation. The French government released Decree No  2019-655 formalising the Inter-dealer Exemption outlined in the letter to the industry with effect from 29 June 2019. The conditions of the exemption remain broadly the same as outlined in the 2019 letter, but the text of the Decree goes slightly further, including a longer list of French counterparties with which own account dealing is permitted under the exemption and allowing for third country firms becoming market members of French regulated markets, MTFs or OTFs. Furthermore, the version of the exemption outlined in the Decree is not limited to derivatives contracts, but covers any transactions on financial instruments or greenhouse gas emission allowance. The extended list of French counterparties covered by the exemption now includes the following public entities: the French State, the Trésor of the French Republic, the Banque de France, La Poste, both the Institut d’émission des départements d’outre-mer and the Institut d’émission d’outre-mer, the Caisse des dépôts et consignations (CDC), the Caisse de la dette publique and the Caisse d’amortissement de la dette sociale. The Decree has been implemented in article D.532-40 of the French financial and monetary Code. In addition, further to the inter-dealer exemption, the French implementation of MiFID II has also allowed the establishment of third country firm branches in the jurisdiction of France. This is allowed on the basis of a cooperation agreement concluded between France and the jurisdiction of the third country firm. The establishment of a branch in France allows such a branch to offer services in France alone, without the benefit of the pan-European MiFID passport. (g) Germany: Currently there is a cross-border licence for which a firm is required to apply to the BaFIN. Although it is not an automatic right to 19

2.34  Authorising and regulating securities dealing in Europe provide services (like the UK  Overseas Persons Exclusion), there are no limitations to the countries from which the overseas firm could be providing its services (unlike the Article 10 exemption in the Netherlands). The licence, when granted by the regulator, allows an institution that is sufficiently supervised in its local jurisdiction to provide services to institutional clients, including corporations, banks and other financial services firms, as well as the German government. In addition, there is consensus amongst the German legal community that, although not stipulated in black letter law, the total sum of various provisions in German legislation would amount to the presence of an inter-dealer exemption, similar to the French inter-dealer exemption. (h) Netherlands: There have been two possible routes to obtaining approval for the provision of cross-border services into the Netherlands. The first is a full cross-border licence which subjects the firm to ongoing supervision by the AFM, the Dutch supervisory authority. This licence is not widely in use and is normally available to smaller firms without significant activities in the Netherlands. It is predicated on a cooperation agreement between the AFM and the competent authority of the third country, but is not limited to specific countries. The second route is an exemption offered to specific jurisdictions, which are predetermined in secondary legislation as meeting a certain regulatory standard. This exemption is referred to as the ‘Article 10 exemption’ and is currently available only to firms located in the US, Australia and Switzerland. (i) Luxembourg: As mentioned earlier in this chapter, Luxembourg had a liberal regime based on characteristic performance. Since 2019, the regime requires active authorisation of third country firms providing services to Luxembourgish clients, thereby still maintaining the ability for such services to be provided, but more along the Danish model. The CSSF has to have concluded an equivalence assessment of a jurisdiction before firms based in that jurisdiction can benefit from a licence into Luxembourg. In fact, the equivalence assessment is triggered by an application submitted by a firm in a third country which has yet to be assessed. To date, the UK (in the context of Brexit) and Switzerland have been assessed as equivalent by the CSSF. The characteristic performance test continues in parallel for all other jurisdictions, as well as for firms in the UK and Switzerland who structure their offering in a way that does not trigger a licensing requirement. (j) Spain: Spain has fully implemented the provisions of MiFID allowing third country firm branches to be established in its jurisdiction, much like Sweden and France. This constitutes a major breakthrough considering that Spain did not previously have an operative regime within which a firm was allowed to provide services from a third country institution. The Spanish model still does not allow direct servicing of Spanish clients from a third country. (k) Sweden: The trigger for authorisation in Sweden is not solicitation but characteristic performance. The question is whether the service is conducted in Sweden. The intensity and frequency of the activity could trigger authorisation requirements. In addition, in the process of implementing Article  39 of MiFID II, Sweden enabled the domestic regulator with authorisation powers for an incoming branch of a third country firm which was previously impossible. Such branches were originally intended to be allowed in the case of an equivalence decision by 20

The European dual track system 2.35 the European Commission, but, absent such equivalence determination, the Swedish authorities can approve the presence of a branch in their own territory from a third-country firm. Since the implementation of MiFID II and in anticipation of Brexit, the Swedish FSA has allowed the presence of Swedish branches of UK investment firms as third country firms postBrexit. United Kingdom: Generally the UK follows a characteristic performance approach and has a liberal attitude to services provided to per se professionals and eligible counterparties from overseas locations. See paras 2.36–2.46 below.

(l)

2.35 The results of the overview of third country access regimes set out above are summarised in figure 2.3 below:

Iceland

Finland

Russia Norway Estonia

Sweden

Latvia Denmark

Lithuania

Irel

and

Belarus United Kingdom

Poland

Netherlands Germany Belgium

Ukraine Czech Republic

Slovakia

Austria France

Switz.

va

do

ol

M

Lux.

Hungary Romania

Croatia Bosnia and Herzegovina

Italy

Serbia

Montenegro

Bulgaria

Portu

gal

Macedonia

Albania

Spain

Turkey Greece

Malta

Cyprus

Ability to provide cross-border investment services from a third country without a branch and without an EU equivalence determination Ability to provide cross-border investment services from a third country with a branch and without an EU equivalence determination No ability to provide cross-border investment services from a third country, without an EU equivalence determination

Figure 2.3  Overview of Third-Country Access Regimes

21

2.36  Authorising and regulating securities dealing in Europe

UK PERIMETER GUIDANCE 2.36 The Financial Services and Markets Act 2000 (FSMA) and the secondary legislation made under it provide the rules and regulations that determine whether an activity requires authorisation in the UK. The main secondary legislation is included in the Financial Services and Markets Act 2000 (Financial Promotion) Order 2005 (SI 2005/1529) (‘Financial Promotions Order’ or FPO) and the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 (SI 2001/544) (as amended) (the ‘Regulated Activities Order’ or RAO), both of which are statutory instruments made under FSMA. A  further layer of rule-making takes the form of guidance in the Perimeter Guidance Sourcebook (PERG) of the FCA  Rulebook. Although PERG gives guidance about regulated activities and financial promotions, it does not aim to, nor can it, be exhaustive. It is intended as an interpretative layer assisting interested parties in understanding the RAO and the FPO. PERG is issued under section 139A of FSMA. It represents the FCA’s views and does not bind the courts. Although the guidance does not bind the courts, it may be of persuasive effect for a court considering whether it would be just and equitable to allow a contract to be enforced (see sections 28(3) and 30(4) of the FSMA). PERG 2 provides the main analysis of when an unauthorised person is not allowed to provide services in the UK without receiving authorisation. Under section 23 of FSMA (Contravention of the general prohibition or section 20(1) or (1A)), a person commits a criminal offence if he carries on activities in breach of the general prohibition in section 19 of the FSMA, which essentially prohibits the provision of regulated services without a licence. 2.37 Although a person who commits the criminal offence is subject to a maximum of two years’ imprisonment and an unlimited fine, it is a defence for a person to show that they took all reasonable precautions and exercised all due diligence to avoid committing the offence. Another consequence of a breach of the general prohibition is that certain agreements could be unenforceable (see sections 26 to 29 of the FSMA). This applies to agreements entered into by persons who are in breach of licensing requirements. 2.38 Under section 22 of FSMA (Regulated activities), for an activity to be a regulated activity it must be carried on ‘by way of business’. Whether or not an activity is carried on by way of business is ultimately a question of judgement that takes account of several factors (none of which, on its own, is likely to be conclusive). These include the degree of continuity, the existence of a commercial element, the scale of the activity, and the proportion which the activity bears to other activities carried on by the same person but which are not regulated. See the earlier example in paragraph 2.15. 2.39 Section 19 of FSMA provides that the requirement to be authorised under the Act only applies in relation to activities that are carried on ‘in the UK’. In many cases, it will be quite straightforward to identify where an activity is carried on. But when there is a cross-border element (for example, because a client is outside the UK or because some other element of the activity happens outside the UK), the question may arise as to where the activity is carried on. 2.40 A person based outside the UK may also be carrying on activities in the UK even if they do not have a place of business maintained by them in the UK (for example, by means of the internet or other telecommunications system or by occasional visits). In that case, it will be relevant to consider whether what 22

UK Perimeter Guidance 2.43 they are doing satisfies the business test as it applies in relation to the activities in question. 2.41 In addition, there are exemptions from authorisation that apply on an EU-wide basis, as they are enshrined in Article  2 of MiFID II, and therefore form part of UK law. Further information about these exemptions is contained in PERG 13.5. To the extent that an investment firm falls within one of these exemptions, it will not be a MiFID investment firm. Where a firm is not a MiFID investment firm because one or more of the exemptions in Article  2 apply, it may still be carrying on regulated activities in the UK and therefore require authorisation unless it is an exempt person, as the UK has certain regulated activities above and beyond the ones included in MiFID. A  prime example of that is the UK activity of arranging (bringing about) deals in investments, which is not a MiFID activity. Under PERG 2.7.7. B, the activity of arranging (bringing about) deals in investments is aimed at arrangements that would have the direct effect that a particular transaction is concluded. The activity of making arrangements with a view to transactions in investments is concerned with arrangements of an ongoing nature whose purpose is to facilitate the entering into of transactions by other parties. This activity has a potentially broad scope and typically applies in one of two scenarios. These are where a person provides arrangements of some kind: (1) to enable or assist investors to deal with or through a particular firm (such as the arrangements made by introducers); or (2) to facilitate the entering into of transactions directly by the parties (such as multilateral trading facilities of any kind other than those excluded under article 25(3) of the RAO, exchanges, clearing houses and service companies – for example, persons who provide communication facilities for the routing of orders or the negotiation of transactions). 2.42 Even though the UK has a broader regulatory perimeter than the activities required to be regulated by European legislation, it also has a series of safe harbours from authorisation that are set out in several exclusions in the RAO. The FCA provides guidance on these exclusions in PERG  2.9.2. The exact terms of each exclusion will need to be considered by any person who is considering whether they need authorisation. Each description is accompanied by an indication of which regulated activities are affected. 2.43 From the perspective of an overseas firm seeking to provide services into the UK, the most important safe harbour is the Overseas Persons Exclusion under article 72 of the RAO. This sets out the conditions under which a service provider can access the UK market without seeking authorisation. The FCA provides guidance on this point in PERG 2.9.15. The Overseas Persons Exclusion applies, in specified circumstances, to the regulated activities of: (1) dealing in investments as principal; (2) dealing in investments as agent; (3) arranging (bringing about) deals in investments and making arrangements with a view to transactions in investments; (3A) arranging a home finance transaction; (3B) operating a multilateral trading facility; (3C) operating an organised trading facility; (4) advising on investments; (5) entering into a home finance transaction; 23

2.44  Authorising and regulating securities dealing in Europe (6) administering a home finance transaction; and (7) agreeing to carry on the regulated activities of managing investments, arranging (bringing about) deals in investments, making arrangements with a view to transactions in investments, assisting in the performance and administration of a contract of insurance, safeguarding and administering investments or sending dematerialised instructions. 2.44 An overseas person is defined as a person who carries on what would be regulated activities but who does not do so, or offer to do so, from a permanent place of business maintained by them in the UK. Where a person does not have a permanent place of business in the UK, they will not, in any event, need to rely on these exclusions unless what they do is regarded as carried on in the UK (see PERG 2.4, on performing the activity remotely). Nor will a person be able to rely on the Overseas Persons Exclusion if, when carrying on the relevant regulated activity, it is a MiFID investment firm and its Home State is the UK. 2.45 Under PERG 2.9.17, the Overseas Persons Exclusion is available for regulated activities in the two broad cases set out below: (1) Where the nature of the regulated activity requires the direct involvement of another person and that person is authorised or exempt (and acting within the scope of his exemption). For example, this might occur where the person with whom an overseas person deals is an authorised person or where the arrangements they make are for transactions to be entered into by such a person. This is sometime referred to as the ‘With or Through’ exemption. (2) Where a particular regulated activity is carried on as a result of what is termed a ‘legitimate approach’. An approach to an overseas person that has not been solicited by them in any way is a legitimate approach. An approach that is made by that person in a way that does not contravene section 21 of FSMA is also a legitimate approach. In such circumstances, the overseas person can, without requiring authorisation, enter into deals with (or on behalf of) a person in the UK, give advice in the UK or enter into agreements in the UK to carry on certain regulated activities. 2.46 Under PERG  2.9.17B(1), the Overseas Persons Exclusion does not apply to an investment firm or credit institution set up in a third country that has been found equivalent under Article  46 or 47 of MiFIR, as, in such circumstances, the process set out under MiFID of authorising institutions set up in an equivalent third country would apply.

BREXIT 2.47 One of the key themes of the Brexit debate was the potential harm that the City of London might suffer through loss of access to the EU’s single market. In essence, one of the sides of the debate had foreseen that, once the UK ceased being a member state of the EU, the privileges that attached to such membership, including the relevant passports in financial services, would also cease to apply. Therefore, UK firms would be unable to continue servicing their existing EU clients or attract new ones, as their automatic right to a services passport would be terminated. Servicing clients without a passport or a local licence would normally be a criminal offence under applicable legislation. In addition, the EU authorities would be particularly focused in ensuring that no 24

Brexit 2.51 such relationship continues surreptitiously, so the enforcement risk would be significant even in marginal cases. 2.48 At this point, this prediction has been borne out, but only partially thus far. The ability of the EU to maintain its integrated single market without diluting the fundamental principles of mutual rights and obligations was stressed by the European authorities in the Brexit negotiation. It is still the single most important driver in the EU’s approach to its future relationship with the UK. If the UK is not part of a ‘club’, it cannot recreate being part of that ‘club’ through a series of trade arrangements with the EU, including in financial services. The tightening of the third country firm regime in the IFR was a warning shot to the UK as to what the future could look like even if the UK were to be granted equivalence by the European Commission under Articles 46 and 47 of MiFIR. 2.49 However, at least in the short to medium term, the interests of the EU also lie in preserving pre-existing services for those who receive them, if that is the only mechanism to avoid economic disruption. A prime example of this is the existence of long-dated derivatives contracts between investment firms in the UK and their EU clients. Such contracts may have a duration that goes beyond the end of the Brexit transition period. Assuming the UK is not an equivalent third country (either because it never qualified as such or because it eventually lost its designation as equivalent), these contracts will not terminate automatically. They are not being declared null and void. However, certain actions foreseen within those contracts, such as any increase in the size of the exposure or (in some jurisdictions) collateral management, could trigger licensing requirements in the jurisdiction of the client. These activities are called ‘lifecycle events’. As the UK firms will not be in possession of an EU licence or passport, their performance of lifecycle events could be viewed as a breach of licensing requirements. A  similar, if not more problematic, issue arose in relation to insurance contracts, some of which may last the duration of the life of the retail customer and therefore several decades beyond the effective Brexit date. Therefore, it would have been very difficult for the EU authorities to insist on a complete disruption of services or a mass migration of these contracts by means of novation to the European affiliates of the UK entities, as the financial cost of such migration might also have to be borne by the client. 2.50 To minimise the impact of a hard Brexit on financial contracts, the authorities on both sides of the English Channel ended up relying on a series of measures allowing periods of adjustment (called ‘emergency measures’) and predicated on a no-deal Brexit. In addition, the authorities of Member States where third country regimes pre-existed in any event allowed UK firms to apply to them in advance of Brexit to preclude the possibility of any disruption to services. In some jurisdictions, the permanent regimes were supplemented by temporary regimes, which allowed clients to continue receiving services from UK providers for a short period (between three and four months) following a no-deal Brexit.

The impact of Brexit on authorisation regimes 2.51 Brexit has had a significant impact on domestic authorisation regimes. Many of the third-country regimes available in Member States by virtue of their domestic legislation had not been fully explored or taken advantage of by thirdcountry firms. Although the regimes existed, the number of firms registered 25

2.52  Authorising and regulating securities dealing in Europe under such regimes were limited. That was certainly the case in Denmark and in Belgium. In the Netherlands, the Article 10 exemption was utilised by some US and Swiss firms, due to its inherent geographic constraints. As mentioned in paragraph 2.34(e) above, the Finnish regime had been completely ignored by international players, to the extent that legislators saw no point in maintaining it in law in the first place and – for a short period – removed it. 2.52 Due to the threat of a type of Brexit that did not include any arrangements for the financial services sector, preserving the continuity of services, these regimes became relevant again and provided a domestic self-preservation mechanism for markets with close proximity and significant interconnectivity with the UK financial services industry. The lack of a deal in financial services at the end of the Brexit Transition Period in December 2020 demonstrated that this approach had been fully justified. 2.53 One of the peculiar legal challenges in providing continuation of services had been that regulators could not consider applications from UK firms while the UK was part of the EU, as the UK could not qualify as a third country under their existing legislation. By assessing an application of a firm that was located in another EU Member State as if it were a third-country firm, regulators would be going beyond the strict meaning of the legislation and possibly be seen as acting politically. However, the majority of regulators that had a regime of that nature at their disposal opted to use it in advance of the date of Brexit and to pre-authorise firms with the date of the end of the Transition Period as the effective date for pre-authorisation. The only significant exception to this approach related to the BaFIN, that resisted all calls to provide such preauthorisations to UK firms.

The centrifugal force of national interests 2.54 What is even more significant is that national interests gave rise to a degree of flexibility hitherto unseen in respect of certain jurisdictions. For example, southern European jurisdictions have been steadfastly following a strategy centred on maximum harmonisation within the European structures, without significant national deviations. However, in the course of the period of 2017 to 2020, the regimes of Spain and Italy became more open. The French regime opened windows of access to the international financial markets. And amongst the newer members of the EU, Finland took steps to reinstate the lost access. 2.55 One should not mistake such approaches as systemic solutions set to stay in force forever. An entity that wishes to access several European markets from outside the EU would find it difficult to comply with the complexities of each separate jurisdiction under which it has received authorisation. The beauty of the single European passport has been that, other than in the case of branches, a firm can comply with applicable requirements simply by following the conduct of business obligations of its home state. That luxury is lost to outsiders, who take a piecemeal approach to accessing the EU. 2.56 It has also been observed, in several debates regarding third country access, and most recently in the context of the IFR implementation, that there is a vocal school of thought that would like to argue for maximum harmonisation of the EU regime, closing down all pre-existing domestic regimes. Therefore, there is always a degree of uncertainty as to whether the centrifugal forces will 26

ANNEX 2.59 continue to preserve for long such domestic arrangements as these, which are seen by some as undermining the common European strategy.

Empty shells and the gravitational pull of the European Central Bank 2.57 The most vocal advocate for relocation of enterprises in a meaningful way from the UK to the EU has been the European Central Bank (ECB). In the early days of the Brexit debate, the presence of these national regimes, together with some political rhetoric that cast doubt over the impact of Brexit on financial services, drove the ECB in stipulating unequivocally that it would not tolerate post-box entities in the EU, where the bulk of the activity takes place in the UK and only some sales activity is located in the EU. Several public pronouncements were made on this point, until the ECB published its supervisory expectations on booking models in 2018 (www.bankingsupervision.europa.eu/banking/relocating/ shared/pdf/ssm.supervisoryexpectationsbookingmodels_201808.en.pdf [accessed 6 August 2021]). In that presentation, the ECB set out its views on ‘empty shells’ and booking models, and provided additional clarifications to banks. It set out the expectation that entities set up in the EU should have the ability to manage their risk in an independent fashion through accessing directly, without the use of overseas affiliates, the international infrastructure of execution venues, clearing houses and settlement systems. The ECB also undertook to assess the impact that booking models can have on the development of a sound risk management and control framework of an entity under its supervision and that entity’s operational resilience in a crisis. The expectations cover a broad set of topics and focus on the risk framework from a first/second line perspective, and are used by the ECB for the assessment of Brexit cases and for carrying out ongoing supervision of existing banking groups that undertake capital markets operations. 2.58 In essence, this was a warning shot against any major institution that considered a slimmed-down approach for its EU operations whilst maintaining the bulk of its presence overseas. The ECB has continued to apply these principles and it remains to be seen whether this gravitational pull will countenance any attempt to rely heavily on the domestic regimes that each member state has sought to buttress.

ANNEX Investment services and activities in MiFID II 2.59 Annex 1, section A  of MiFID II sets out the following investment services and activities: ‘(1) Reception and transmission of orders in relation to one or more financial instruments. (2) Execution of orders on behalf of clients. (3) Dealing on own account. (4) Portfolio management. (5) Investment advice. 27

2.60  Authorising and regulating securities dealing in Europe (6) Underwriting of financial instruments and/or placing of financial instruments on a firm commitment basis. (7) Placing of financial instruments without a firm commitment basis. (8) Operation of an MTF. (9) Operation of an OTF.’

Ancillary services in MiFID II 2.60 Annex 1, section B of MiFID II sets out the following ancillary services that may be provided in conjunction with the investment services and activities in section A: ‘(1) Safekeeping and administration of financial instruments for the account of clients, including custodianship and related services. (2) Granting credits or loans to an investor to allow him to carry out a transaction in one or more financial instruments, where the firm granting the credit or loan is involved in the transaction. (3) Advice to undertakings on capital structure, industrial strategy and related matters, and advice and services relating to mergers and the purchase of undertakings. (4) Foreign exchange services where these are connected to the provision of investment services. (5) Investment research and financial analysis or other forms of general recommendation relating to transactions in financial instruments. (6) Services related to underwriting. (7) Investment services and activities, as well as ancillary services of the type included under Section A or B of Annex 1 related to the underlying of the derivatives included under points (5), (6), (7) and (10) of Section C where these are connected to the provision of investment or ancillary services.’

Financial instruments in MiFID II 2.61 Annex 1, section C  of MiFID II sets out the following financial instruments: ‘(1) Transferable securities. (2) Money-market instruments. (3) Units in collective investment undertakings. (4) Options, futures, swaps, forward rate agreements and any other derivative contracts relating to securities, currencies, interest rates or yields, emission allowances or other derivatives instruments, financial indices or financial measures which may be settled physically or in cash. (5) Options, futures, swaps, forwards and any other derivative contracts relating to commodities that must be settled in cash or may be settled in 28

ANNEX 2.62 cash at the option of one of the parties other than by reason of default or other termination event. (6) Options, futures, swaps, and any other derivative contracts relating to commodities that can be physically settled, provided that they are traded on a regulated market, an MTF, or an OTF, except for wholesale energy products traded on an OTF that must be physically settled. (7) Options, futures, swaps, forwards and any other derivative contracts relating to commodities that can be physically settled not otherwise mentioned in (6) above and not being for commercial purposes, which have the characteristics of other derivative financial instruments. (8) Derivative instruments for the transfer of credit risk. (9) Financial contracts for differences. (10) Options, futures, swaps, forward rate agreements and any other derivative contracts relating to climatic variables, freight rates or inflation rates or other official economic statistics that must be settled in cash or may be settled in cash at the option of one of the parties other than by reason of default or other termination event, as well as any other derivative contracts relating to assets, rights, obligations, indices and measures not otherwise mentioned in this Section [(1)–(11)], which have the characteristics of other derivative financial instruments, having regard to whether, inter alia, they are traded on a regulated market, an OTF, or an MTF. (11) Emission allowances consisting of any units recognised for compliance with the requirements of Directive 2003/87/EC (Emissions Trading Scheme).’

Client categories in MiFID II 2.62

Annex 2 to MiFID II provides as follows:

‘PROFESSIONAL CLIENTS FOR THE PURPOSE OF THIS DIRECTIVE Professional client is a client who possesses the experience, knowledge and expertise to make its own investment decisions and properly assess the risks that it incurs. In order to be considered to be professional client, the client must comply with the following criteria: I. CATEGORIES OF CLIENT WHO ARE CONSIDERED TO BE PROFESSIONALS The following shall all be regarded as professionals in all investment services and activities and financial instruments for the purposes of the Directive. (1) Entities which are required to be authorised or regulated to operate in the financial markets. The list below shall be understood as including all authorised entities carrying out the characteristic activities of the entities mentioned: entities authorised by a Member State under a Directive, entities authorised or regulated by a Member State without reference to a Directive, and entities authorised or regulated by a third country: (a) Credit institutions; 29

2.62  Authorising and regulating securities dealing in Europe (b) Investment firms; (c) Other authorised or regulated financial institutions; (d) Insurance companies; (e) Collective investment schemes and management companies of such schemes; (f) Pension funds and management companies of such funds; (g) Commodity and commodity derivatives dealers; (h) Locals; (i) Other institutional investors; (2) Large undertakings meeting two of the following size requirements on a company basis: — balance sheet total:

EUR 20 000 000

— net turnover: EUR 40 000 000 — own funds: EUR 2 000 000 (3) National and regional governments, including public bodies that manage public debt at national or regional level, Central Banks, international and supranational institutions such as the World Bank, the IMF, the ECB, the EIB and other similar international organisations. (4) Other institutional investors whose main activity is to invest in financial instruments, including entities dedicated to the securitisation of assets or other financing transactions. The entities referred to above are considered to be professionals. They must however be allowed to request non-professional treatment and investment firms may agree to provide a higher level of protection. Where the client of an investment firm is an undertaking referred to above, the investment firm must inform it prior to any provision of services that, on the basis of the information available to the investment firm, the client is deemed to be a professional client, and will be treated as such unless the investment firm and the client agree otherwise. The investment firm must also inform the customer that he can request a variation of the terms of the agreement in order to secure a higher degree of protection. It is the responsibility of the client, considered to be a professional client, to ask for a higher level of protection when it deems it is unable to properly assess or manage the risks involved. This higher level of protection will be provided when a client who is considered to be a professional enters into a written agreement with the investment firm to the effect that it shall not be treated as a professional for the purposes of the applicable conduct of business regime. Such agreement shall specify whether this applies to one or more particular services or transactions, or to one or more types of product or transaction.’

30

3 Dealing in securities and the primary obligations

This chapter will examine the following points: •

The different functions that investment firms play in securities dealing.

•

How these functions map to the regulated services and activities set out in European legislation.

•

How these functions give rise to conflicts requiring management.

•

The key obligations that stem from such activities in respect of: –

conduct of business;

–

market transparency; and

–

public disclosure.

ORDERS, RFQS AND EXECUTIONS IN THE CONTEXT OF SECURITIES DEALING 3.1 To understand the legal and regulatory implications arising from dealing in securities, one needs to examine first the way the different interactions of investment firms with their clients are defined and described in securities law.

Client orders and indications of interest 3.2 An order is any request or instruction sent by a client to a firm to buy or sell a specified product, at a given price for a given time, that is not simultaneously executed. An example of an order is an instruction to buy 100 ten-year bonds of Microsoft for no more than US$100 in the course of this trading day. A request that meets this definition but is also conditional (eg ‘if you can locate the bond’) still constitutes an ‘order’. By contrast, an indication of interest is only an order if it is actionable in the market without going back to the party that expressed interest. For example, a client may ask the firm: ‘If it gets to this level (eg US$100) call me’. That type of instruction is not an order. There can be cases when the communication with the client includes a mixture of client instructions, giving rise to doubt whether a client has placed an order, in which case the firm would seek to clarify that with the client through further communication. 31

3.3  Dealing in securities and the primary obligations 3.3 At the point that the order is firmed up, ie the client and the investment firm are both clear on the terms (contractual certainty), the investment firm has an obligation to conclude the transaction if the terms are met. At the point when the transaction is concluded, for instance the investment firm has sourced the bonds or shares the client has requested, the investment firm has ‘executed’ the order.

Simultaneous execution 3.4 A  simultaneous execution takes place when a trade occurs simultaneously with reaching an agreement as to all the final terms of the trade with the counterparty. In other words, the time of execution is the time at which the terms of the trade were agreed by the counterparty and the trader. For example, a client calls the salesperson and asks for a bid on a bond (a ‘request for a quote’ or RFQ). The salesperson then calls the trader who quotes a bid. If the client, the salesperson and the trader all agree at the same time to execute the trade at those quoted terms the trade is simultaneously executed. In that case, there is no separate order in the sequence, only an execution.

Receipt of orders 3.5 Orders may be received by email or instant message under certain circumstances that allow the details of the order to be fully recorded. Normally the details of the order are also required to be inputted into an order entry system maintained by the investment firm. Clients may often provide order instructions by FIX connections. Orders sent via FIX connection automatically enter a firm’s electronic routing and trading systems. The order details are then maintained in the same manner as any other order in the system for a client.

RECORD KEEPING 3.6 MiFID requires that firms create and maintain certain records of orders and trades. If a firm and its employees fail to complete accurate records of orders and trades then the risks faced by the firm cannot be properly managed and an accurate audit trail would not be available for use in reconstructing sales and trading activity and detecting regulatory violations. 3.7 To document orders, the person that receives such order would normally be expected to record the following elements; •

identity of the firms receiving the order;

•

account/subaccount identification;

•

symbol and/or product;

•

side of market;

•

order instructions including any terms or conditions associated with the order, for instance duration of order, handling requests;

•

order price, spread and yield line number of shares or quantity line order type, eg market limit, stop limit;

32

How to understand Annex I of MiFID 3.11 •

name of salesperson responsible for the account;

•

name of person receiving the order if different from above;

•

name of trader if applicable;

•

terms and conditions of the order, for instance, duration, special handling requests limit, VWAP, etc;

•

designations if the order is solicited or unsolicited; and

• timestamp.

TRADE BOOKING 3.8 At the core of any regulatory investigation, whether conducted by the regulator or by the internal compliance function of an investment firm, lies the ability to access accurate records. For instance, the ability to decide if a trader has ‘traded ahead’, in other words, whether they have executed a proprietary trade on the back of information received regarding a client’s trading intention thereby taking advantage of the privilege of their own position (a potentially abusive practice), is dependent on the existence of accurate records of when the trader received the client information and when the trader placed the trades in the market. That is why there is immense focus on the complete, accurate and timely recording of orders and trades by firms. 3.9 In terms of timing, the immediate and accurate booking of transactions on the trade date is essential to ensure the accuracy of any firm books and records. The late booking of transactions may result in a broad range of regulatory deficiencies. Sales and trading staff are responsible for entering the trade into the relevant booking systems. If a trader routes an order to the floor of an exchange or to another trading business for execution, it is the routing trader’s responsibility to book the trade immediately upon receiving confirmation from the exchange or executing broker that the trade has been executed. If a trader executes a client trade without the direct involvement of a salesperson, eg  if the trader enters into a simultaneously executed trade directly with the client or if the trader executes a standing order, the trader would normally inform the relevant salesperson so that the salesperson can enter all trade details into their sales entry system. 3.10 In circumstances where a trader is providing the position that the client is requiring rather than executing the transaction in the market, execution time is a required trade attribute and is defined as the time when parties to the transaction have agreed to all the terms of the transaction that are sufficient to calculate the price of the trade. If there is any delay in booking a trade, the trader must ensure that actual time of execution is captured in the trade booking systems to facilitate accurate reporting.

HOW TO UNDERSTAND ANNEX I OF MIFID 3.11 Now that the sequence of receiving an order or RFQ and providing execution has been explained, it is important to understand the terminology applicable to sales and trading activity in Europe by mapping those activities to the list of services and activities set out in MiFID II Annex I, Sections A and B. 33

3.12  Dealing in securities and the primary obligations •

When a salesperson engages in a discussion with a client regarding a financial instrument, such interaction may fall within the definition of providing investment advice (MiFID II Annex I, Section A, para  3), especially if the salesperson has tailored their views to the needs of the particular client.

•

If, on the other hand, the same salesperson provides investment research and financial analysis or other forms of general recommendations relating to a transaction in financial instruments, this would not constitute investment advice as it is not specific to that client’s portfolio of investments or their specific investment aim but is of broader interest to larger groups of clients. This activity would correspond to MiFID II, Annex I, Section B, para 5.

•

When the salesperson is successful in their interaction with the client and therefore receives an order from the client, the salesperson may be engaging in the regulated service of reception and transmission of orders in relation to one or more financial instruments. This would be the case if the salesperson redirects the order to the execution desk of another legal entity. Reception and transmission of order from a sales desk to an execution desk of the same legal entity would normally be viewed by regulators as a single activity, that of executing client orders.

•

Alternatively, a salesperson may be enabled or permitted to self-execute orders on exchanges. That is common in Europe and the US and it is considered to fall within the activity of sales trading. Sales traders may receive an order from a client in financial instruments and submit this order directly onto an exchange or multilateral trading facility at which point the trade would be executed on the platform in the name of the sales trader. This activity would correspond to MiFID II, Annex I, Section A, para 2

•

If, on the other hand, the salesperson believes that the client is better served or would prefer to receive a price for an instrument available within the firm’s inventory, the salesperson would normally inquire of a trader within the same firm regarding the price of that instrument. The trader would normally look at their book, decide whether they do have that instrument readily available and would also look at the market to see if they can hedge themselves effectively. Then they would decide what price to offer in that instrument to the salesperson and by extension to the client. The trader’s activity in this scenario is considered as dealing on own account which is set out as a service in MiFID II, Annex I, Section A, para 3. In parallel, the investment firm may also be viewed as executing orders on behalf of clients as the firm has received an order from the client and has provided execution services.

3.12 Certain regulators in Europe, and in particular the AMF in France, prefer an interpretation of MiFID according to which ‘dealing on own account’ is not a service conducted without the parallel provision of ‘executing client orders’ at the same time (thereby triggering Annex I, Section A, para  2). This interpretation is based on the guidance by CESR (Working Document ESC-07-2007: Opinion on the scope of best execution under MiFID and the implementing directive) relating to best execution in the context of bilateral transaction, ie  dealing on own account (see para  9.13). CESR required that firms dealing on account should not ignore their best execution duties but 34

How to understand Annex I of MiFID 3.16 should apply the same standards as those applied to executing a client order. Certain regulators decided to reverse-engineer from this guidance that dealing on own account must always be interpreted as executing client orders. Even though that approach is doubtful, it is important that firms are cognisant of that line of thinking as they may be required to apply for an additional authorised activity in such jurisdictions. 3.13 In certain instances, sales personnel may be involved in the activity of placing of financial instruments without a firm commitment basis, which normally originates in the investment banking/capital markets division of a firm (MiFID II, Annex I, para 7). The way these transactions originate is normally through the provision of services to a corporate client or investing client that already has an existing position in a company. Placement is the form of running a book in securities and placing those securities for the client disposing of the positions with those clients who would like to invest in the securities. A different version of this activity includes the provision of a firm commitment, which means that the broker that places the instruments with investors also provides a commitment that any instruments that have not been successfully placed with investors will be bought by the broker itself. This constitutes the activity of placing of financial instruments with a firm commitment basis (MiFID II, Annex I, para 6). 3.14 There may also be circumstances when an investment firm does not service clients on a bilateral basis but instead aims to bring multiple buying and selling interests by multiple participants together in a system. Normally these activities, to the extent that they are systematic, correlate to the activity of operating an MTF or and OTF. Multilateral trading and its nuances will be covered in Chapter 6. 3.15 In addition to the principal services and activities, there is a number of services and activities that attract authorisation when provided in conjunction with the former. If provided on a standalone basis such services could possibly be viewed as either unregulated or regulated within the confines of a different regulation. For example, providing custody services on a standalone basis to clients is a service that would normally be viewed as a banking activity provided by a credit institution, akin to providing the service of deposit taking. Similarly, providing loans to individuals or corporations may be regulated in some jurisdictions as a banking activity. A broker would therefore be unable to provide these services on a standalone basis, unless the broker constituted part of a banking institution authorised to undertake the activities on a standalone basis under its banking licence. By contrast, should the broker be an entity that is regulated as an investment firm only (not a bank), it would only be able to provide these services in connection with its principal MiFID services and activities. For example a broker may be able to hold the securities of its client in an account dedicated to client holdings, if such securities have become the property of its client by virtue of the client’s consumption of execution services through this broker. It is also possible for the broker to provide financing (often secured against the client’s holdings) to provide the client with greater purchase power in the context of the execution services it provides. When brokers provide financing and custody alongside execution, the industry calls that holistic activity prime brokerage. 3.16

The mapping has been set out in the table below 35

3.16  Dealing in securities and the primary obligations MiFID Regulatory terms II Annex I, II

Investment Services and Activities

Reception and transmission of orders in relation to one or more instruments Execution of orders on behalf of clients

36

Function in the finance industry to which the term applies Sales

Description of activity performed in the context of the regulatory term Accepting an order for a client and redirecting to an execution desk, or another broker

Sales trading (For sales traders) accepting an order from a client and submitting directly on a venue for execution Trading (For traders) providing an execution service to an internal sales desk or to the client directly Dealing on own Trading Making markets (quoting bid and account offer prices) on a venue Responding to RFQs from clients OTC and concluding a trade with them Portfolio Asset Determining the best allocation of Management managers assets for investing clients who have entrusted the asset manager with performing the task within certain investment parameters Investment Advice Sales Taking into account what the client Financial wants to achieve and proposing an advisers investment or a trading strategy tailored to the client’s needs Assisting a corporation with Investment Underwriting of the flotation of its securities on financial instruments banking an exchange, by placing the Trading and/or placing of securities with investing clients financial instruments and committing that any unplaced on a firm securities will be held by the broker. commitment basis Assisting a corporation or a Placing of financial Investment disposing client with finding the instruments without banking other side of the trade, ie a buyer of a firm commitment Trading the securities. basis Operating a multilateral system Operation of an Venues that brings together multiple thirdMTF in shares party buying and selling interests in and RFQ platforms in financial instruments to conclude fixed income transaction, in accordance with noninstruments discretionary rules Operation of an OTF Interdealer Bringing together multiple thirdbrokers party buying and selling interests in financial instruments to conclude a transaction, in accordance with discretionary rules. Typical of an interdealer broker, ie a broker that takes no risk, but only brings together and matches buyers and sellers of the same instruments.

Investment Services and Activities

How to understand Annex I of MiFID 3.16 Safekeeping and administration of financial instrument

Prime brokers Private wealth managers

Granting credits or loans to an investor to allow him to carry out a transaction Advice to undertakings on capital structure, industrial strategy and related matters and advice and services relating to mergers and the purchase of undertakings Foreign exchange services where these are connected to the provision of investment services

Prime brokers Investment banking

Holding instruments on behalf of clients (custody of shares or bonds), in connection with execution services provided to them, in the case of prime brokers. In the case of private wealth managers, custody is provided in conjunction with execution services and/or discretionary portfolio management. Providing financing to clients to allow them to maximise their trading capability, typical of the role of a prime broker. Classic advisory services provided to corporations by investment bankers, helping corporations optimise their strategy in terms of their capital structure, or mergers and acquisitions.

Sales FX services connected to settling Trading transactions in the preferred Sales trading currency of the client rather the currency in which the security is listed. FX services connected to any other service provided to the clients, such as custodian services, etc. Producing broadly disseminated Investment research Research division of a analysis on markets, the economy, and financial specific companies, commodities, broker analysis or other currencies, central bank policies. Sales forms of general This research is then distributed by recommendation the sales force of the firm to clients, relating to with a view to attracting their transactions in execution business. financial instruments Services related to Investment When a corporation lists its shares underwriting banking or bonds on an exchange with the assistance of an investment bank that underwrites that flotation, that investment bank will also perform a number of services, including the transfer of the shares to investing clients, the support of the flotation in its early day through stabilisation, etc. All services that are provided in Investment services Sales relation to underlies of derivatives Trading /activities and Sales trading in context of providing services ancillary services in respect of the derivatives Prime (all fields above) transactions, eg transfer of bonds in brokers related to the respect of a bond derivative. underlying of derivatives

37

3.17  Dealing in securities and the primary obligations

CONFLICTS OF INTEREST 3.17 To understand the separation of sales from trading in an investment firm, one needs to examine the role that each function plays in servicing the client. A salesperson is there to facilitate client flow and to ensure that the client receives general market colour and sufficient information to make their own investment decisions. In that regard, the salesperson is aligned with the interests of the client. There are several occasions where it might be possible that the client’s best interests are better served through receiving execution outside the confines of the investment firm. For instance, a client that wants to receive 100 shares in Vodafone may find that their wishes can be better satisfied by receiving that execution on the Stock Exchange rather than having it fulfilled by the investment firm’s own inventory. The salesperson would normally consider the options available to the client if the client is flexible regarding the question of location of execution. 3.18 By contrast, a trader needs to ensure that the inventory that they manage is managed well and therefore ought to offer competitive prices to customers of the firm but always within the risk appetite that the firm has set for that inventory. In a sense, the trader is confined by the limitations of their own book. if the trader decides that they would rather not be active in the market at a specific time because of volatility, then they can either refuse to provide a risk price or provide a price that is set at an uncompetitive level. This is normal behaviour and demonstrates that the interests of the trader lie primarily with driving the success of their own portfolio of positions, their own inventory. One can therefore see that the interests of the salesperson (representing the client) are not always aligned with the interests of the trader (representing the potential for the firm to make a profit by utilising its own portfolio). 3.19 Saying that the interests are not aligned does not necessitate that their interests are diametrically opposite or that they are never aligned. If, for instance, the client wants to buy a particular security for which the trader has the most competitive prices, it is possible that the interests of the client would be best served by an execution against that trader’s position and that the trader at the same time will generate profit for the firm by putting its portfolio to good use. 3.20 Another potential conflict of interest arises inherently for the salesperson in the servicing of multiple of clients. If two clients are interested in making the same investment in the same instrument and there is sparseness of liquidity in that instrument, there are very clear rules as to which client needs to be prioritised and on what basis, to ensure that there is fair and equitable treatment of clients. 3.21 A firm that has both a brokerage arm and an investment banking division has to grapple with the potential conflicts arising from the misaligned interests of the clients of the two divisions. The investment banking division, in its role of advising a corporation on its options, is interested in ensuring that the securities issued by the corporation are priced as highly as possible, are all placed with investors and that such investors have the intention to hold such investments in the long run. The brokerage arm, on the other hand, having been tasked by the firm with the distribution of the corporation’s securities has to consider the interests of the investing clients. These clients would prefer to receive the securities at as low a price as possible and often would include investors with a trading strategy that does not include the retention of these securities in their portfolio for a long time. 38

Conduct of business obligations 3.27 3.22 When concentrating on sales and trading specifically, conflicts can be grouped in the following broad categories; • conflicts between the investing clients of the firm and the firm’s own principal trading arm; • conflicts between two clients of the same function/division; • conflicts between clients of one function versus clients of another (for instance, investing clients of a brokerage division versus the corporations that are clients of the investment banking division); and • conflicts between interests of financial markets at large and the interests of the firm. 3.23 Conflicts are unavoidable and therefore European law and regulation recognises that they can be managed in multiple ways. This is set out in the MiFID  Org Regulation (Commission Delegated Regulation (EU) 2017/565 of 25 April 2016 [2016] OJ L87/1) and in FCA SYSC 10. There are specific methods of conflict management in several rules, beyond the general principles. Some of these specific mechanisms for management of conflicts are: • strict principles of allocation of services to clients requiring the same service, based on time priority or proportional allocation. A prime example of this treatment of conflict is the order handling rule for clients (FCA COBS 11.3); • yielding to a client’s interests, when the conflict is between the firm’s own interests and those of the client’s; • disclosure of the conflict to clients before they decide to proceed; • express consent by the clients in respect of specific scenarios; and • information barriers between parts of the firm representing conflicting interests, for instance between sales and trading, or between the brokerage arm and investment banking. 3.24 To the extent that conflicts cannot be managed, a firm has to decline to act for a client in the circumstances. 3.25 Management of conflicts is one of the two key drivers of financial services regulation, after investor protection, and drives several of the conduct of business obligations that apply to sales and trading.

CONDUCT OF BUSINESS OBLIGATIONS 3.26 When providing investment services to clients, there are certain requirements that always have to be complied with. They are the rules of engagement with clients, with which sales and trading employees should be familiar with. Conduct of business obligations are numerous, but some key ones are set out below.

Client classification 3.27 Prior to the provision of services, a firm is required to have classified the recipient of the services as a client. As part of client classification, the firm places the client in a category: an eligible counterparty, a professional client, or a retail client, in ascending order of protection. Generally, firms utilise the client 39

3.28  Dealing in securities and the primary obligations categorisation criteria that were set out at para 2.62, but clients have the ability to seek a lower categorisation, meaning a higher level of protection and firms have to inform clients of this right. Client categorisation is relevant to application of specific rules. For instance, best execution obligations are not owed to eligible counterparties and some of the inducements rules are relaxed for such clients. It is common for clients who themselves provide financial services to other customers to ask for the higher level of protection granted by the status of professional client or even retail client, as that allows them to demonstrate better the satisfaction of their own obligations to their customers. The process of client categorisation is subject to strict record-keeping requirements for the relevant firm.

Communication with clients 3.28 In their interaction with clients, firms are subject to general principles of clarity and completeness, to ensure that the investing public is making decisions on a clear basis. This applies to both existing clients and prospective clients. The overarching principle is that a firm must ensure that the communication is fair, clear and not misleading (COBS 4.2.1.). As the sophistication of the client dictates how much information they need for clarity, a firm can implement this requirement proportionately in respect of the three main categories of clients. For instance, a firm may have to explain to a retail client the impact of placing an order without a limit price but will certainly not be required to do so for a professional client or an eligible counterparty.

Providing a written agreement 3.29 In its dealings with professional and retail clients, a firm is required to provide a written agreement setting out the rights and obligations governing the relationship. For sales and trading firms setting out the rights and obligations, key provisions would include the expectation of settling transactions in a timely fashion and the right of the firm to deal in the securities that the client has dealt in, if the client does not fulfil their settlement obligation (right of sale). There are also extensive provisions of liability, and in particular the limitation of liability of the firm providing the execution services to the client, if any part of the execution chain (for instance an exchange or a broker) fails to perform their own obligations to the firm, in the course of fulfilling a client’s orders. General outages of market infrastructure are also excluded from the liability attaching to the firm, by virtue of force majeure clauses. There is also a very clear complaints provision, for the client to seek redress. The firm sets out a high-level disclosure of conflicts that may arise in the course of conducting its business. Finally there are provisions of governing law and of jurisdiction in the case of a dispute. All the features above are essential in an agreement, but the content may be a lot broader than that, often covering aspects such as the definition of a client, if the client is a portfolio manager with underlying accounts, the right of set off between transactions with the same client or with the same advised accounts of the client, and other topics.

Assessing suitability when giving investment advice 3.30 In the case of the provision of investment advice (very limited circumstances in sales and trading), the firm must perform a suitability assessment. For instance, a firm may provide a tailored trade idea to a client, in respect of a 40

Conduct of business obligations 3.32 combination of investments. An airline company may be interested in an oil trade to hedge its exposure to future fuel needs and the fluctuation of oil prices. A firm cognisant of this client’s needs may decide to propose to the airline a particular trade in oil. In this case, it must obtain the necessary information from the client to be able to give due consideration as to whether a recommended investment meets the investment objectives of the client, whether the client is financially able to bear the investment risks in line with the client’s investment objectives, and to ensure that the client has the necessary knowledge and experience to understand the risks of the transaction. On the basis of that information, a firm may decide that the transaction is unsuitable for the client. In the case of the airline, the test may not be satisfied if the trade proposed were instead a trade in gold. Suitability is a test that is derived from retail investing, where financial advisors often recommend new products to their investing clients. Its use has later been further expanded to more sophisticated clients but there are proportional rules on the assumptions a firm can make for the purposes investment advice when it comes to professional clients and eligible counterparties. For instance, the requirement to assess the client’s sophistication is immediately satisfied if the client has been correctly categorised as a professional client or eligible counterparty.

Best execution 3.31 A firm is also due to provide clients with best execution, unless they are eligible counterparties. Best execution is derived from the duty of firms – and in the case of sales and trading, brokers in particular – to act in their clients’ best interest and forces firms to think carefully about the venue of execution of their clients’ trades. Firms have to demonstrate that they have executed their clients’ orders or requests for quote in a way that aimed to achieve the clients’ objectives as expressed through the application of different execution factors. Best execution is an important foundation of execution services and there is a detailed discussion of best execution in Chapter 9.

Inducements 3.32 The existence of conflicts of interests in sales and trading and the requirement to manage such conflicts is demonstrated by the handling of inducements. There is an expansive regulatory framework restricting the ability of the firm to derive a benefit for itself (or to cause a third party to benefit) from the business it conducts with its clients other than through the receipt of payment for the services it provides to that client. A prime example of that would be a situation where the firm promotes an investment to a client and the client decides to buy that investment, unaware that the firm is also receiving a promotional payment or discount by the manufacturer of the investment. That promotional payment or discount is an inducement which would be impermissible and the firm would be required to disclose its existence to the client and in several cases to pay it over to the client. There are also inducements which are permissible, for instance offering to a firm’s own clients a promotional discount in respect of the firm’s standard fees. Generally, benefiting one’s own clients is permissible, although such initiatives should be governed by the principle of treating customers fairly, which requires the establishment of criteria to determine which clients would benefit and which would not. Aspects of the inducements regime are further examined in Chapter 5, together with the dealing commissions rules. 41

3.33  Dealing in securities and the primary obligations

MARKET TRANSPARENCY 3.33 Markets can only operate in an orderly fashion if there is sufficient data available to allow the different actors in the market to perform their role. For instance, best execution can only be provided to clients if the broker has sufficient information regarding where the greatest liquidity (the greatest number of trades) is found for that security. The broker can only identify the market where the greatest liquidity is if there is sufficient information made available to that and other brokers as close as possible to real time. To ensure that this becomes possible in a way that market participants can rely on the information, regulation requires that exchanges and other organised venues, as well as dealers who provide liquidity bilaterally to their clients, publish information on the executed trades immediately or no later than at a specified time (one minute in shares, other timeframes for other asset classes). The trade reports are time stamped and are fed through authorised publication mechanisms to anyone who wants to consume this information. This is what is called ‘posttrade transparency’. Similarly, when a venue brings together buying and selling interests, it is required to give access to market participants to the indicative prices that are available in the central limit order book. This is what is defined as ‘pre-trade transparency’. Pre-trade transparency is also applicable to dealers that systematically stream prices to clients (systematic internalisers, on which further information is provided in Chapter 6). To ensure that market participants are not artificially excluded from such information through inflated pricing, the regulation sets out a strict requirement for this information to be made available to market participants on a reasonable commercial basis. 3.34 The requirements are set out in Articles  3 to 21 of MiFIR and are summarised below.

Pre-trade transparency 3.35 Any venue in equities, equity-like instruments (for instance, ETFs, or certificates), bonds, structured finance products, emission allowances or derivatives is required to make public the bid and offer prices and the depth of trading interests at those prices. Some trading venues in equity and equitylike instruments can apply for and receive waivers from this requirement, if the venue rules are such that the provision of this information will not enhance the knowledge of the investing public. Prime example of such a venue is one which is tied to or ‘pegged’ to the prices of an exchange, meaning that it only allows executions to take place at specific price points predetermined by the exchange’s own published prices. Such a venue could benefit from a reference price waiver and therefore does not have to make public pre-trade information. Such venues are often called ‘dark venues’ and the liquidity that they provide is called ‘dark liquidity’. Although the term ‘dark’ may have negative connotations, it is only a reference to the contrasting term used for venues that publish pre-trade information: they are called ‘lit venues’. 3.36 The requirement for pre-trade transparency is not limited to venues on which brokerage firms trade but extends to the bilateral trading activity of dealers which trade systematically in an instrument. A dealer dealing systematically in an instrument (otherwise called a ‘systematic internaliser’) needs to provide transparency as to the prices at which they are willing to trade. Depending on 42

Regulatory and public disclosure regimes 3.39 the financial instrument that the dealer is dealing in, the requirements vary. For equities and equity-like instruments that are normally traded on a venue, the dealer must make prices public for trading interests in sizes which are relatively small (at least 10% of standard market size). For non-equity instruments, the requirement is only to make available to other clients of the firm the ability to trade on a quote if that quote has been made available to another client. The information on the trading interest is therefore not made available to the public. This is a recognition that non-equities are often instruments with limited liquidity and therefore the provision of such information to the market at large may compromise the ability of the dealer to be active in that market. More detail is provided on the regime applicable to systematic Internalisers in Chapter 6.

Post-trade transparency 3.37 As mentioned above, venues must make public information regarding trades executed on their platform immediately after such executions take place. The information included in this published data relates to the price, volume and time of transactions executed on the venue. Although these reports are public and of course are identifiable by the venue on which they have been conducted, the identity of the parties to the trade (the buyer and the seller) is not visible. There are certain exemptions to the requirement to publish the information immediately. If a trade is of a very large size (there is a scale of what constitutes a large trade, depending on the liquidity of the security), the publication of the information on the trade is delayed for several hours, sometimes until the ‘open’ of the following trading day. The purpose of such delay is to allow the dealers who provided this liquidity to a counterparty, and who have therefore assumed outsized risk, enough time to manage that risk. If the venue were to publish details of the trade immediately, the market participants would learn of the trade and move to trade immediately on the back of the information, thereby creating adverse trading conditions for the dealer who had provided the liquidity for the large trade in the first place. By giving dealers this window to manage or ‘unwind’ the risk, regulators recognise that dealers would be otherwise less willing to facilitate such large transactions. 3.38 Post-trade transparency requirements are also relevant for dealers who trade bilaterally with clients systematically (systematic internalisers) or just trade on a habitual basis (over the counter dealers). They are also required to provide information regarding their executed transaction to a publication mechanism, what is commonly called the ‘tape’. They are required to provide information on the time of execution, the security, the volume and the price of the transaction. The name of the dealer does not appear to the market through the publication mechanism.

REGULATORY AND PUBLIC DISCLOSURE REGIMES Transaction reporting 3.39 Regulators require full transparency on the trading activity undertaken by regulated firms with their clients. Such transparency is fundamental for the purposes of ensuring that they can look for patterns of behaviour as part of their monitoring for market abuse (see Chapter 4). The way in which regulated 43

3.40  Dealing in securities and the primary obligations firms provide that detail to regulators is through the submission of transaction reports. These are private disclosures, meaning that only regulators have sight of them. As the purpose of the disclosure is the monitoring of orderly trading and avoidance of market abuse, the regulators are only interested in financial instruments that are traded on a trading venue (and therefore susceptible to market abuse) or derivatives over these instruments. 3.40 Under Article 26 of MiFIR, a transaction report would normally identify the client on whose behalf the transaction was executed, the regulated firm that provided the service, the venue to which the order was transmitted or executed, the security in which the transaction took place and details of timing, pricing and quantity of securities. It also indicates the legal capacity in which the regulated firm acted. All regulated firms including those that operate a trading venue are required to provide a transaction report to their regulator. This means that for a transaction where a portfolio manager (regulated as a MiFID investment firm) instructs a broker (also regulated as a MiFID investment firm) to execute a transaction in a security on an exchange, the relevant regulators for each party in the chain would receive a transaction report, a total of three transaction reports, which should – if accurate – all match together. These reports are submitted on the day after the day of the trade, as they are for review by the regulators rather than immediate publication to the market.

Shareholding disclosures 3.41 Under the Transparency Directive (TD), any investor that exceeds certain thresholds of holdings in a listed company is required to make a public disclosure to ensure that the market is aware of its holdings. The TD, issued in 2004 and revised in 2013, aims to ensure parity of information amongst investors through a regular flow of disclosures of periodic and on-going regulated information and the dissemination of such information to the public. Regulated information consists of financial reports, or information on major holdings of voting rights. 3.42 The main regulatory technical standards derived from the TD were published in the Official Journal of the European Union (Commission Delegated Regulation (EU) 2015/761 of 17 December 2014). In order to contribute to the consistent application of the TD, ESMA has published a standard form for shareholders to notify major holdings of voting rights to competent authorities and issuers as required under the TD. 3.43 Under the TD, a shareholder acquiring or selling shares has to notify the issuer of such transactions as soon as the acquisition or disposal of shares results in an amount of voting rights that exceeds, falls below or reaches the threshold of 5%, 10%, 15%, 20%, 25%, 30%, 50% and 75% of the total amount of voting rights issued. The disclosure is public. This means that investors and salespeople have at their disposal information about the existing interest in a company through the register of major shareholders and can therefore provide ideas to clients on strategic trades using this information. As these thresholds of disclosure are the minimum harmonised standard in the EU, several Member States of the EU have introduced more detailed disclosure requirements, commencing at a lower than 5% threshold and possibly being triggered at small increments. There are also two main exemptions from disclosure, applicable to market makers and firms using their trading book. These exemptions are limited in the size of disclosure 44

Regulatory and public disclosure regimes 3.48 they obviate but are also applied differently across different jurisdictions of the EU. The TD regime is therefore one of the most complicated regimes that can be navigated and is ripe for harmonisation in the EU.

Short selling regime 3.44 Market participants may want to capitalise on the falling price of a stock through selling a security even if they do not presently own the security in their inventory. This is normal behaviour for certain trading strategies but may also arise naturally when a firm facilitates a request from a client to buy the security and the firm does not at that point have the security in its inventory but intends to buy it afterwards. The activity of selling a security which is not already settled in the seller’s inventory is called ‘short selling’. By contrast, when a firm sells securities that it already possesses, those sales are called ‘long sales’. 3.45 Short selling is a normal feature of financial markets. However, it is often blamed for accentuating downward spirals in a share’s price. Regulators have therefore sought visibility into the market participants who undertake this activity, so that they can probe any predatory behaviour which they think stems from an improper activity. This transparency is achieved through the Short Selling Regulation (SSR). Under the SSR, there is a requirement to make a private disclosure of short positions to the competent authority if the short position built in a particular security exceeds certain thresholds. When this position reaches certain higher thresholds, a public disclosure of the short position is necessary: significant net short positions (NSPs) in shares must be reported to the relevant competent authorities (when they reach 0.2% of the issued share capital and every 0.1% above that) and disclosed to the public (when they reach 0.5% of the issued share capital and every 0.1% above that). 3.46 Additionally, the SSR introduces other requirements: • all short sales of shares must be covered (ie naked short selling in shares is banned); and • all short sales of sovereign debt instruments must be covered (ie  naked short selling in sovereign debt is banned) and all credit default swaps positions related to a sovereign issuer must not lead to uncovered positions (ie naked sovereign CDSs are banned). 3.47 Cover in these cases means that a market participant is free to engage in short selling a share or a sovereign bond, but they have to first ‘locate’ the instruments. This means that they have to request from a broker to confirm that the broker has the instruments in the inventory, so that when the time comes for the market participant to settle the sale, two days after the trade, the market participant can borrow the share or bond from the broker for settlement, for a fee. 3.48 Exemptions from need to cover short sales are included in the SSR for market making activities and authorised primary dealers. The market making exemption also allows firms which facilitate client transactions to avoid disclosure as they are not positioning themselves strategically in respect of a company with a negative outlook. They are simply facilitating other market participants. These exemptions are important for sales and trading firms as otherwise their capacity to be present at all times to cover the needs of market participants would be very much compromised. 45

4 Market abuse regime in the EU

In this chapter, the following key elements of the regime will be explored, always with the focus of a sales and trading practice: • the key legislative framework; • key technical provisions that have been a focal point of discussion in recent years; and • proposals for review of the regulatory regime and the ESMA recommendations.

THE OBJECTIVES OF A MARKET ABUSE REGIME 4.1 In our industry, knowledge is power. Being better informed than the rest of the market participants means you can look into the future like no other and achieve optimal results. Similarly, outwitting the competition by being smarter, quicker, more nimble, means that one can produce better results for the firm and its clients. The question that market abuse regulation is trying to address is where the limit should be drawn in respect of this ‘special knowledge’ and what techniques one can legitimately deploy. The key drivers for market abuse regulation are: • protecting trading participants through information parity: defining what it is assumed everyone knows or ought to know versus what becomes so valuable that it has to be treated as a special information flow with ‘conditions of usage’. It also forces public disclosure of information that ought not to be restricted in the privileged possession of the few. Relevant rules here would include the public disclosure regime, the approach to inside information and the wall crossing processes; • protecting investors at large from predatory practices: considering the sophistication of the majority of the market and creating a framework that allows for certain legitimate trading practices but protecting investors from trading hawks who can outwit them with special underhand techniques. Relevant rules here would include all aspects of market manipulation, rules relating to handling client orders and pre-hedging; and • protecting the listed companies and ultimately investors in those companies: proscribing practices that lead to extreme fluctuations, whilst creating protection for stratagems that may look in the face of them as manipulative but actually seek to benefit the stability of the company and the investing public. Relevant rules in this category would include the stabilisation safe harbour and the buy-back safe harbour. 47

4.2  Market abuse regime in the EU 4.2 None of these rules can be prescriptive in enormous detail. The landscape in trading techniques or means of disseminating information has evolved enormously over the years. Detailed rules would not therefore be able to keep up with the evolving reality. They set out fundamental practices that are outlawed, but case law and iterative regulatory guidance has helped define better the latest practices that are either acceptable (creating formal or informal safe harbours) or illegal. The field of market abuse regulation is perhaps the area of regulation with the greatest number of rules relying on examples or guidance to set out defensible practices. In the UK, prior to the implementation of the Market Abuse Regulation (MAR) in 2016, the market relied heavily on the Code of Market Conduct of the FCA which set out in significant detail the regulator’s guidance on acceptable practices. As MAR is a regulation which therefore does not allow national implemention variation but only direct transposition into national law, the UK had to delete the Code of Market Conduct from the UK rulebook, although the industry still consults it as a means of understanding supervisory expectations. 4.3 It is accepted by most commentators that certain egregious trading practices of the past have changed with the greater focus of the authorities on this area and the evolving understanding of what is acceptable. This often happens with a more detailed understanding of existing practices, renewed regulatory focus or simply enhanced sensitivity to the rules, resulting in practices that had been in place for decades unchecked without any issues now being officially found to be abusive, such as in the case of the LIBOR rate fixing.

SALES AND TRADING AND THE MARKET ABUSE REGIME 4.4 Practically every aspect of sales and trading is impacted by the market abuse regime. Some of the conflicts of interest that were explored in the previous chapter are also relevant in this context. For instance, knowledge of a client’s trading intentions could possibly itself constitute unlawful knowledge of inside information unless the person has come to know the information as part of the process of providing a service to the relevant client. Hence, the sensitivity about the separation of sales (handling client interests and client information) and trading (prioritising the firm’s interests) is not simply based on confidentiality but also on the principle of enhancing confidence in the orderly function of the market and the maintenance of market integrity. 4.5 The underlying principle of market integrity is that all market participants have parity of information, which means that their investment strategy should be based on publicly available information and on their analysis of the economic fundamentals, rather than on privileged access that allows them an advantage over other market participants. Having access to the best economists, the best economic modelling, the best engineers devising efficient algorithms, and to the best data sources are all legitimate goals and are encouraged by regulators to ensure that the end investor receives value for money in the investing process. By contrast, a shortcut to success based on illegitimate access to non-public information constitutes a violation of the market abuse regime and may bring about very large administrative penalties, as well as, in some cases, criminal penalties. 4.6 Similarly, a market participant who uses trading techniques which are not reflective of a genuine investment strategy, with a view to making a quick 48

MAR: the main violations and scope 4.9 profit against the rest of market participants, may be found to be manipulating the market. There are several examples of such strategies all of which may benefit the person that deploys them to the detriment of other investors and of market orderliness. Engaging in market manipulation is also a type of market abuse, which is very clearly proscribed, with several examples of that set out in ancillary legislation. 4.7 The market abuse regime permeates the entire financial markets ecosystem, including the activity of all investors irrespective of whether they themselves are regulated or not. With the specific lens of sales and trading, the market abuse regime is relevant when analysing the ability of a firm to provide services to its clients, if the clients are acting in violation of the market abuse regime themselves. It is also very relevant for the brokerage arm of a firm per se, as due to its role it is often in the middle of information flows. Navigating the market abuse regime carefully is required to allow the firm to act for its own purposes – for instance to hedge its own risk. Being an intermediary between clients, and between clients and the markets, entails a high risk that the firm is in the middle of information flows which, viewed under a certain light, may look like the firm’s integrity is compromised. Careful handling of information, in line with information barriers or wall crossing techniques is therefore key for the maintenance of the firm’s integrity and to ensure that its activity meets regulatory expectations.

MAR AND MAD II 4.8 The Market Abuse Regulation (EU/596/2014) (MAR) in combination with the Market Abuse Directive II  (2014/57/EU) (MAD II) succeeded the original Market Abuse Directive (2003/6/EC) which had been implemented in 2006, a year before MiFID  I. The combined MAR and MAD II included significant revisions and thanks to the use of a regulation (MAR) for certain parts of the architecture, there was little room left for regional variation in the EU of the different standards. Following the departure of the UK from the EU, the regime was also separately ‘on-shored’ in the UK; in other words it continued to apply in the UK in the form of domestic legislation.

MAR: THE MAIN VIOLATIONS AND SCOPE 4.9 The two main violations that may take place by any person (whether that person is regulated or not) are ‘insider dealing’ and ‘market manipulation’. Both of these activities, which will be examined in more detail below, must relate to a financial instrument admitted to trading in the EU or a derivative over such an instrument. This expansive application was introduced with MAR and MAD II, whereas previously the scope was focused on securities listed in the EU. With more instruments being admitted to trading following the implementation of MiFID and later MiFID II, the universe of instruments is particularly expansive. One of the most challenging aspects of MAR is that the activity in scope can take place anywhere in the world, as long as the instruments are in scope. So, in theory, a Japanese customer purchasing from a US bank a bond issued by a German corporate listed on the Frankfurt Stock Exchange may be committing the offence of insider dealing in Germany, if it is acting on inside information, even if the client or the bank that services that client have no establishment in 49

4.10  Market abuse regime in the EU Europe. The ‘extraterritorial’ nature of MAR is a key feature of the legislation, which allows the authorities to take action, often in coordination with other authorities overseas, in fighting market abuse globally.

Inside information – insider dealing 4.10 One of the two key pillars of MAR is the prohibition against insider dealing and unlawful disclosure of inside information under Article 14 of MAR. 4.11 To understand insider dealing one needs to establish first what is inside information. According to Article 7 of MAR, information can qualify as inside information if it possesses the following three characteristics: (1) It is of precise nature – in other words information about facts in existence or reasonably expected to come into existence, which would enable one to a draw a conclusion as to the effect of these facts on the price of the investment (Art 7(2)). For instance knowledge of the intention of a listed company to make a takeover bid would be precise enough, as it would be impactful on that company’s share price. The same is true if the company had taken preparatory steps which meant that a takeover bid was reasonably foreseeable. By contrast, a market expectation that oil companies may cut down production due to lower oil demand is not precise enough to qualify as inside information. (2) It is not public – normally, public information has become public through disclosure required of companies under the listing rules of the jurisdiction in which the company is listed. The type of information that is made public this way includes key economic performance information (for instance profit warnings), material contractual changes, or changes to the composition of the company’s board. When an announcement has been made through the relevant stock exchange there can be no doubt that the information is public. There are other situations in which concluding whether the information is actually public is not as straightforward. For instance, a group (syndicate) of lenders who have provided collectively finance in the form of a loan to a listed company will have information on the performance by the company of its obligations under the loan. If the company has renegotiated the terms of the loan or has delayed payment of an instalment, the lenders may have information about the company being in possible financial difficulty. Depending on the size of the syndicate, the information may be viewed as being public, but – to be on the safe side – the analysis should be undertaken with caution: dealing in the company’s securities if the information about the loan performance is not public could be an offence. (3) if it were to be made public, it could have a significant effect on the relevant prices of financial instruments, etc if it were to be used by a reasonable investor in their investment decisions. 4.12 A person commits the offence of insider dealing where a person is in possession of inside information in relation to a financial instrument and uses this information in dealing in that instrument, for instance by buying, selling, amending orders, cancelling existing orders, or encouraging others to do so (Art 8 of MAR). It is important that the behaviour is in relation to any action that a person may take rather than just sales and purchases. 50

MAR: the main violations and scope 4.20 4.13 An example of insider dealing comes from the famous case of Greenlight Capital, which resulted in a fine in 2012 by the FSA against Greenlight Capital and its founder David Einhorn for trading on inside information. The FSA stated in its final notice that the actions of Einhorn and Greenlight amounted to ‘a serious case of market abuse’. 4.14 It is important to distinguish between on the one hand the approach taken in the UK and the EU in such cases under the European market abuse regime and on the other hand the US approach which would not view trading on price sensitive information as market abuse unless there was a duty to disclose that information in the first place or to abstain from trading (what the US terms the ‘classical’ theory). (See Decision Notice to David Einhorn, 12  January 2012, available at www.fca.org.uk/publication/decision-notices/dn-einhorngreenlight.pdf [accessed 3 August 2021].) 4.15 In the Greenlight Capital matter, the FSA alleged the following key facts. In June 2009, funds managed by Greenlight held approximately 13.3 percent of Punch Taverns Plc’s outstanding equity. Punch’s board of directors engaged an investment bank to enter into discussions with certain shareholders, including Greenlight, regarding a potential private placement of Punch’s equity following the shareholders entering into a standard non-disclosure agreement—a so-called ‘wall cross’ offering. Einhorn declined to enter into the nondisclosure agreement but agreed to participate in a conference call during which he claims he stated he was to receive no inside information. During the conference call, Einhorn learned, among other things, that Punch was at an advanced stage of the process toward an equity offering, the principal purpose of which would be to repay Punch’s outstanding convertible debt and create a cushion with respect to certain covenants in Punch’s securitisation vehicles. 4.16 Immediately following the conference call, Greenlight began to sell its shares of Punch. During the three days following the call, Greenlight sold 11.65 million Punch shares, reducing its holding in Punch from 13.3% to 8.98%. 4.17 Six days after the conference call, Punch informed the market of its intent to raise £375 million in an equity offering. The price of Punch’s shares fell approximately 30%, which resulted in Greenlight avoiding losses of approximately £5.8 million by selling in advance of that public announcement. 4.18 The FSA concluded that Einhorn had engaged in market abuse by trading on the information learned during the conference call. 4.19 Specifically, the FSA found that the information: • indicated that ‘an equity issuance might reasonably be expected to occur’; • was specific enough to ‘enable a conclusion to be drawn as to the possible effect of the issuance on the price of Punch shares’; • was not public; and • ‘was likely to have a significant effect on price.’ 4.20 There is a question of course of how specific the information provided at the meeting was. It related to preparatory steps that might or might not result in certain action taken by the company, ie the prospective placement of equity that would be dilutive to the interests of the existing shareholders. In addition, it is clear that Greenlight had put the onus on Punch to not disclose any nonpublic information as Greenlight had refused to sign a confidentiality agreement. Punch, nevertheless, proceeded with the meeting and provided information that, 51

4.20  Market abuse regime in the EU with the benefit of hindsight, tainted Greenlight. Greenlight would be prohibited from trading in its own holdings by virtue of the information that it inadvertently received. Two issues here arise that are addressed by MAR: (1) The status of comments regarding preparatory steps: it has often been argued that information may be devoid of precision by virtue of the fact it relates to steps which may lead to an outcome. For instance a discussion on a major transaction like the rights issue of Punch could have been viewed as too uncertain, as there was no absolute certainty that it would go ahead and, if it did, what its exact timing would be. Indeed, some very vague speculation would probably fall short of the standard set by the legislation. If a person spoke of thinking of selling some securities, this information would not be precise enough unless one knew the actual size or order of magnitude of the sale and the timing or general timeframe. But concrete steps that would lead to an action with price impact, such as briefing shareholders about the intention to proceed with a rights issue does give the recipient of the information sufficient information of the direction the company is heading in and can be precise enough under the definition. Article 7(2) of MAR sets that out clearly by considering information as being of a precise nature ‘if it indicates a set of circumstances which exists or which may reasonably be expected to come into existence, or an event which has occurred or which may reasonably be expected to occur, where it is specific enough to enable a conclusion to be drawn as to the possible effect of that set of circumstances or event on the prices’ of the investment. ‘In this respect in the case of a protracted process that is intended to bring about, or that results in, particular circumstances or a particular event, those future circumstances or that future event, and also the intermediate steps of that process which are connected with bringing about or resulting in those future circumstances or that future event, may be deemed to be precise information.’ (2) Processes to ensure avoidance of inadvertent tainting: an unfortunate element of the Greenlight Capital case was the receipt of information by a person, when that person had made it clear that he did not want to receive inside information. The unwilling receipt of information is called tainting in the industry. Tainting someone with inside information could sometimes be a weapon in trading as it results in blocking someone from trading in those securities. An attempt to taint someone with inside information would normally be viewed as suspicious and would be notified by the impacted party’s compliance department to the relevant competent authority as suspicious activity. How is it then possible to explore opportunities to transact, if there is no ability to legitimately communicate with another party your willingness to do so? To the extent that someone is in possession of such information and would like to conclude a transaction, the legislation stipulates a process of legitimate approach within very tight parameters, called ‘market soundings’. This process constitutes a ‘safe harbour’ under Article 11(4) of MAR: a market sounding comprises the communication of information, prior to the announcement of a transaction, in order to gauge the interest of potential investors in a possible transaction and the conditions relating to it such as its potential size or pricing, to one or more potential investors. The disclosing market participant, before making the disclosure, must: (a) obtain the consent of the person receiving the market sounding to receive inside information; 52

MAR: the main violations and scope 4.21 (b) inform the person receiving the market sounding that they are prohibited from using that information, or attempting to use that information, by acquiring or disposing of, for their own account or for the account of a third party, directly or indirectly, financial instruments relating to that information; (c) inform the person receiving the market sounding that they are prohibited from using that information, or attempting to use that information, by cancelling or amending an order which has already been placed concerning a financial instrument to which the information relates; and (d) inform the person receiving the market sounding that by agreeing to receive the information they are obliged to keep the information confidential. 4.21 If that protocol had been followed in the Greenlight case, the rejection by Einhorn of the approach by Punch would mean that Punch would not be able to proceed further and to provide the information as it planned.

Figure 4.1 Insider dealing

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4.22  Market abuse regime in the EU

Handling client information and the conundrum of insider dealing 4.22 As mentioned earlier, brokerage services by definition require broker personnel to be in the middle of information flows thereby exposing them to significant risks of insider dealing or sharing inside information. A client wishing to sell a meaningfully large position in a company would communicate their intention to their broker. At that point, the broker is obviously ‘tainted’ in principle, so under the legislation they should not be in a position to conclude any transactions in the market. However, under Article 9(2)(b), MAR allows the professional executing the client’s order to deal in the securities stipulated by the client. The same carve-out applies also to dealers making prices to clients (Art 9(2)(a)). 4.23 Although it is clear that the firm can execute the client’s order either by placing it on the market or by filling it as a principal, the more complex question centres on the firm’s ability to be allowed to execute trades in respect of its own existing inventory when it receives a client order in the same stock. If the firm intended to sell its own inventory position, would it be possible to do so when it is in possession of a large selling or buying order from the client? In principle, the firm would not be able to deal in its own holdings while executing its client’s order. However, there are two exceptions to this prohibition: (1) Segregation of desks: if the firm has a principal trading desk dealing in its own securities but its client facilitation desk is occupied by different personnel with sufficient information flow segregation, then the principal desk can continue to deal in the firm’s own holdings, in complete ignorance of the upcoming activity of the client facilitation desk. Article 9 of MAR establishes some safe harbours for legitimate behaviour of that kind. It also helps with the existence of an investment banking arm of a firm which is in possession of inside information on a company that it advises. The trading arm of that same firm may continue trading in the securities of that company, if there are sufficient procedures in place to ensure that the inside information is not shared with the traders. Firms normally have information barriers between investment banking and sales and trading divisions to ensure that the activity of the latter is not impeded by the activities of the former. This is a very important carve-out for brokerage firms, to ensure their on-going functioning within complex institutions. (2) Pre-hedging: upon the receipt of some indication of interest from a client (not a specific order with clear quantity, target price, direction, etc), the firm can consider whether it should prepare itself for taking on the risk of that execution by trading in the market. The purpose of that activity should always be for the purposes of facilitating the potential client trade (not as speculative activity for the firm’s own interest) and should always be concluded with the client’s consent and with sufficient steps to minimise market impact. 4.24 After the firm has executed a client transaction, it is free to deal in the same securities in any event and will probably need to do so to ensure that it can hedge its exposure if it concluded the transaction as a principal.

Market manipulation 4.25 One can be harmful to other market participants not just through the misuse of confidential information but also by spreading false rumours or giving 54

MAR: the main violations and scope 4.28 false impressions. To protect market participants, there is a prohibition against market manipulation stipulated in Article 15 of MAR. Market manipulation is defined in MAR as an attempt to create a false or misleading impression in relation to a financial instrument (Art 12 of MAR). This may include creating a false impression through deliberately pursuing a trading activity that sends misleading signals to the market or by spreading misleading information. 4.26 A classic case of market abuse and market manipulation can be found in the notorious City Slickers case (The Times, 11 February 2006). Although the case was prosecuted on market abuse grounds, the case is equally reflective of market manipulation. Two journalists writing a financial column in the Daily Mirror, called City Slickers, made a profit on several occasions by writing in their column that certain shares were tipped to go up, cognisant of the fact that the paper’s influence would result in price impact for these shares: several of the readers would follow the tip, thereby driving the price of the relevant shares up through their buying activity. The journalists would use the following pattern. First they would buy shares of certain companies in advance of the publication of the paper. Then they would include those shares in the hot tips of the column. After the news article had an impact on the price, the journalists would then cash in, by selling the shares they had bought, thereby making significant profits. Over the course of the eight-week trial, the jury heard that the journalists had made significant profits through trading in stocks which were tipped in the column between August 1999 and February 2000. During November 1999, one of them also began to leak details of the Slickers tips onto an investor bulletin board on the internet, using an alias, in the hope of generating a positive momentum in the share price ahead of his tip. 4.27

The FCA has provided some additional examples of abusive behaviour:

•

A trader holds a short position that will earn him a profit if a particular financial instrument, which is currently a component of an index, falls out of that index. The question of whether the financial instrument will fall out of the index depends on the closing price of the financial instrument. He places a large sell order in this financial instrument just before the close of trading. His purpose is to position the price of the financial instrument at a false, misleading, abnormal, or artificial level so that the financial instrument will drop out of the index so as to make a profit.

•

A fund manager’s quarterly performance will improve if the valuation of his portfolio at the end of the quarter in question is higher rather than lower. He places a large order to buy relatively illiquid shares, which are also components of his portfolio, to be executed at or just before the close. His purpose is to position the price of the shares at a false, misleading, abnormal, or artificial level.

4.28 Of course, electronic trading offers ample opportunities to create misleading impressions, as the speed and response of electronic signals can provide the perfect environment for creating artificial impressions to other participants, by which they are lured to trade in a way that benefits the mastermind of such impressions. ESMA provided several such examples in the now withdrawn ESMA Electronic Trading guidelines (24 February 2012 | ESMA/2012/122 (EN)). The guidelines had been issued by ESMA to ensure a common, uniform and consistent application of MiFID and MAD. They were subsequently withdrawn as they had been largely incorporated in subsequent guidance in MiFID and MAR. 55

4.29  Market abuse regime in the EU 4.29 The ESMA electronic trading guidelines included the following abuse types of behaviour that were particular to electronic trading: •

Ping orders: entering small orders in order to ascertain the level of hidden orders and particularly used to assess what is resting on a dark platform.

•

Quote stuffing: entering large numbers of orders and/or cancellations/ updates to orders so as to create uncertainty for other participants, slowing down their process and to camouflage one’s own strategy.

•

Momentum ignition: entry of orders or a series of orders intended to start or exacerbate a trend, and to encourage other participants to accelerate or extend the trend in order to create an opportunity to unwind/open a position at a favourable price.

•

Layering and spoofing: submitting multiple orders often away from the touch on one side of the order book with the intention of executing a trade on the other side of the order book. Once that trade has taken place, the manipulative orders will be removed.

4.30 However, general profit seeking is completely legitimate. As the FCA highlights, it is unlikely that the behaviour of trading venue users when dealing at times and in sizes most beneficial to them (whether for the purpose of long-term investment objectives, risk management or short-term speculation) and seeking the maximum profit from their dealings will of itself amount to manipulation. Such behaviour, generally speaking, improves the liquidity and efficiency of trading venues.

Stabilisation: legitimate form of market manipulation 4.31 Although manipulating the impression of other market participants is prohibited, there is one case where it is firmly encouraged: during the launch of a new offering of shares to the public. During the initial trading period, when there may be increased volatility in the market, investors could suffer sudden losses as the price of the share is getting to an appropriate level. The authorities therefore allow for the existence of a designated stabilisation agent that will undertake the stabilisation of the price. Stabilisation of securities is intended to provide support for the price of an initial or secondary offering of securities during a limited time period if the securities come under selling pressure, thus alleviating sales pressure generated by short term investors and maintaining an orderly market in those securities. It thus contributes to greater confidence of investors and issuers in the financial markets (Recital 6 of Delegated Regulation 2016/1052; Article 5(4)(a) of Regulation (EU) No 596/2014). 4.32 The period over which stabilisation may take place cannot exceed the first 30 days of trading, although it may be shorter, or it may not take place at all. Stabilisation is not allowed to be an excuse to artificially inflate a price above its target price. In the case of an offer of shares or other securities equivalent to shares, stabilisation of the securities cannot be carried out above the offering price. During the stabilisation period, the persons appointed as stabilisation agent are required to provide adequate public disclosure of the details of all stabilisation transactions no later than the end of the seventh daily market session following the date of execution of such transactions. A comprehensive disclosure of all stabilisation activity takes place after the end of stabilisation period. 56

Proposed revisions to MAR 4.36

Market soundings, insider lists and cleansing events 4.33 Market soundings as defined in Article 11(1) of MAR are a legitimate mechanism for sharing insider information with prospective investors without committing an offence. It is one of the most useful aspects of the regime in relation to sales and trading. For example, a large investor in a listed company would like to sell 5% of the shares. A broker is tasked with finding buyers for that stake. This amount of shares must be placed privately with large investors otherwise the impact on the share price of such a large selling activity could be very detrimental to the seller. The existence of the intent to sell such a large stake would qualify as inside information under the test above. Disclosing this information to someone would fall foul of Article  10(1) of MAR. To be able to approach potential buying investors without inadvertently ‘tainting’ them, the broker can use the mechanism of market soundings. Recital (33) of MAR provides additional examples in this respect. 4.34 Once someone has received inside information, they must be placed in an insider list. Article 18(1) of MAR requires persons who are in possession of inside information to be placed on an insider list. This includes employees and officers but also external advisors. There is a permanent insider section for individuals who are permanently insiders. This represents the list of individuals who have actual access rather than potential access. ESMA reconfirmed that view in its final report. As ESMA notes, the purpose of Article 18 is not only the investigation of potential cases of market abuse but also the management by the issuer of flows of inside information. 4.35 Market soundings place significant burden on the recipient of the information, as – following the receipt of the information – they are prohibited from dealing in the securities of the issuer (they are deemed wall-crossed). The question that often arises is what is the event that would allow them to be ‘cleansed’ of the information. It is often the case that a transaction is abandoned and the recipient of the information does not know that this has taken place. It therefore has to allow a reasonable time to pass before it can consider the information as ‘aged’ and no longer inside information. This potential for interpretation can create an uneven playing field between firms that take a different approach to the ageing of the information.

PROPOSED REVISIONS TO MAR 4.36 Like all pieces of financial regulation, MAR has been subject to periodic review. Under Article  38 of MAR, the European Commission is required to present a report to the European Parliament and the council to assess various provisions of MAR. In turn, the European Commission asked ESMA to provide a report on some of the more difficult aspects of MAR. ESMA’s report, published on 23 September 2020 (ESMA70-156-2391), covers a series of interesting topics such as buyback programmes, delayed disclosure of inside information and the usefulness of insider lists. In addition, ESMA has provided information on the extension of MAR to spot FX and includes proposals to improve the reporting and transparency obligations derived from buyback programmes. In relation to spot FX contracts, ESMA has opined that MAR need not be amended to include spot FX contracts. Given the sheer number of orders and transactions generated in the spot FX market, ESMA noted the significant cost such extension would 57

4.37  Market abuse regime in the EU entail both for the regulators and the market participants. It also noted that the FX Global Code has addressed several aspects of FX trading which are similar, although not identical, to the requirements of MAR. The FX Global Code set standards that broadly coincide with those set out in MAR in respect of disclosure of inside information unlawfully. ESMA concluded that it was appropriate for a spot FX regime to be considered but in conjunction with central banks (who had helped develop the FX  Global Code) and also with global coordination. This would normally require a significant period of coordination and in-depth discussion, so one should not expect major legislative initiatives in the spot FX space in the near future.

Reporting obligations under the buyback programmes for issuers 4.37 MAR requires the issuer of shares which are subject to a buyback programme to make notifications of the buyback programme not only to the regulator but also to the venue on which the shares are admitted to trading. As such venues may be multiple following the proliferation of venues after the implementation of MiFID II, that obligation may be onerous. ESMA reiterated that issuers should only have to report to the most relevant venue in terms of liquidity and such venues are published by ESMA itself and the information reported is expected to be more limited in nature.

Definition of inside information 4.38 ESMA had to consider whether the definition of inside information is still sufficient to cover all information necessary for fighting market abuse and to narrow it down for the purposes of giving additional certainty to investors. It decided to leave it unchanged other than in respect of Article  7(1)(d) of MAR, which relates to persons engaged in front-running. The current version of the definition limits cases of front running to individuals who are tasked with executing client orders. A  trader or a salesperson in the examples given in para 3.11 could fall foul of the offence of front-running as they are engaged in the execution of client orders. However, there may still be other categories of individuals such as the officers of the listed company itself who may be able to commit the offence. To capture such groups, ESMA proposes to eliminate the words in Article 7(1)(d) that specify ‘persons charged with the execution of orders concerning financial instruments.

Pre-hedging 4.39 On pre-hedging, ESMA could not arrive at a conclusion as to whether it is of benefit to the market. However, they have agreed that pre-hedging should be viewed as a risk management tool for the broker, to contain the exposure derived from possible orders for which an RFQ has been submitted. It also stipulates that this activity should be designed to benefit the client. It does not appear to be the end of the road for reviewing pre-hedging by ESMA, as it notes additional assessments needed to ascertain whether its usefulness is limited to illiquid instruments and its impact on the markets. ESMA also intends to 58

Proposed revisions to MAR 4.40 issue further guidance for market participants to assess whether the behaviour constitutes market abuse. The factors to take into account would include whether there is: • a clear mandate by the client; • disclosure of the activity to the client in advance; • passing the benefit to the client; • minimising impact on the market; and • ex-post disclosure on how the activity was carried out.

Market soundings 4.40 In relation to market soundings, ESMA has proposed the continuation of the market soundings regime along the lines that it currently exists. It has however recognised that market soundings do need to stay broad and cover situations when a transaction is concluded without a public announcement or is abandoned (which also results in no public announcement). Therefore, they would like to delink the definition of market soundings from the timing of an announcement. To address this, they propose to include the words ‘prior to the announcement of a transaction, if any’. ESMA also recommends that if the transaction is announced, there will be no requirement to cleanse under the procedures (Art 11(6) of MAR).

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5 Dealing commissions and the unbundling challenge

This chapter will cover: • the concept of dealing commissions and the types of services for which they have traditionally been used; • the conflicts of interest that may arise in the consumption of these services by portfolio managers; • the history of regulatory interventions in the US, the UK and the EU in the use of dealing commissions; • the current state of regulation in the EU; • ways in which brokers can price services to comply with the constraints of the inducements rules; and • the global impact of the European rules.

INTRODUCTION: WHAT ARE DEALING COMMISSIONS? 5.1 There are few issues in recent years that have been as vexed and as politicised in financial regulation as the issue of unbundling dealing commissions. The very concept has pitted the UK authorities against other European regulators, the EU authorities collectively against the US regulators and the buy-side against the sell-side. At the core of the debate is a series of potential conflicts of interest arising in the execution chain: the paying investor who is often shouldered with hidden frictional costs; the portfolio managers who are choosing to transact with brokers on factors other than best execution; and the brokers incentivised to compete to please the portfolio managers by offering extra services, not merely the execution services that are at the core of their service. 5.2 To explore the history of the debate we have to look at this chain of relationships and the benefits that they bestow on each party through the use of dealing commissions. 5.3 In the example in figure 5.1 below, there is a classic case of so-called ‘agency’ trading. This means that the broker receives an order from a portfolio manager which it then places on an exchange or another liquidity provider for execution. The transaction chain normally begins with the portfolio manager getting in touch with the broker (over Bloomberg chat or through other live communication means) to discuss opportunities in the market. This may be initiated either by the portfolio manager or the broker itself, seeking to be helpful to the portfolio manager by understanding their trading strategy and looking to help them achieve good results in their portfolio. It may be the case 61

Figure 5.1  What are dealing commissions – life of a trade

5.1  Dealing commissions and the unbundling challenge

62

Introduction: what are dealing commissions? 5.5 in this example that the broker has reached out to the portfolio manager with a view that the share of Vodafone would be a good purchase opportunity. At that point, the portfolio manager may decide that this is not the right time to purchase Vodafone shares but does register that the broker’s sales force is looking out for the portfolio manager’s interests (a positive service to the client). In this example, the portfolio manager does decide to purchase 1,000 Vodafone shares. So, they place the order with the broker who then places that order on the exchange successfully and purchases 1,000 Vodafone shares on behalf of its client (the portfolio manager) for GBP1,000. We now have an execution which should result in the settlement of the trade two days later (T+2), ie  there will be a transfer of the shares in the portfolio manager’s account in exchange for cash. This is called delivery versus payment settlement (DVP) and the transfer of cash and securities happens contemporaneously in two steps. The clearing house (which has the obligation to deliver the shares deriving from the on-exchange trade) transfers to the account of the broker (the member of the exchange) 1,000 Vodafone shares and the broker pays the clearing house GBP1,000 plus costs for execution and clearing services (a fee that is calculated as a small percentage of the value of the cash payment for the shares). The second step, that takes place at almost the same time, involves the transfer of shares to the portfolio manager’s account by the broker for the receipt of a cash payment which consists of GBP1,000 plus a fee. That fee is the dealing commission, the size of which varies from broker to broker and depends on the complexity of the services that the broker offers to the portfolio manager. It can be as little as two basis points (0.02%) or as high as 15 basis points (0.15%) or even higher. The dealing commission is expected to compensate the broker for its execution services but also for the additional services which the portfolio manager receives from the broker, such as sales and research services. It therefore exceeds significantly the execution and clearing costs that the broker has incurred versus the exchange and the clearing house. 5.4 By sales services above, we refer to the original interaction that the broker has had with the portfolio manager over which the Vodafone shares were proposed as a good option. These types of interactions normally originate from a specialist sales force that has spent time understanding the portfolio manager’s strategy and is reviewing the market for opportunities which may be fruitful for the client. It is not just restricted to a simple proposal as in the example above, but may be as elaborate as a complex trade idea. For instance, a downturn in the price of oil may give rise to opportunities of selling indices that have a strong representation of oil exploration companies whilst purchasing the component shares of the same indices that are not as exposed to the price of oil. That is a trade idea that is not as simple as a single purchase of one lot of shares but requires multiple orders to be placed with the broker. 5.5 Other than a sales force, brokers often have independent research divisions which host analysts performing economic analysis. These research divisions are set up as independent functions within a firm, behind information barriers, and take long views about the economic fundamentals of companies, sectors, regions, assets or currencies. They produce reasoned economic reports, often accompanied with a conclusion as to whether that particular investment should be kept, sold or purchased. These reports are published on regular basis and are refreshed when the fundamentals that underpin the analysis change, so that the reports remain up-to-date. This type of content is very expensive to produce (several experts have to be permanently employed to produce it) 63

5.6  Dealing commissions and the unbundling challenge and, depending on its quality, can be very highly valued by the industry and in particular portfolio managers. A portfolio manager reading such a report from the independent research division of a broker may be driven to put a specific trading strategy in process to take advantage of the analysis provided by the research analyst and to materialise a profit or to avoid losses from their existing portfolio placement. We will be referring to this content in this chapter as ‘research’. 5.6 The difference between sales and research is that sales often provides short-term commentary on market conditions and opportunities that arise by the way the market has moved intraday, but does not produce analysis on the fundamental economics of sectors, neither does it have the hallmarks of independence that a research division within a broker has. By contrast, sales are embedded within the trading function of the broker and have visibility of aggregate client flows (orders) that come through the trading channel of the broker. The visibility of client flow provides sales with significant intelligence as to prospective market moves and is also valuable to portfolio managers.

POTENTIAL CONFLICTS OF INTEREST 5.7 As both research and sales are valuable to portfolio managers, when they receive this service from a broker, they are incentivised to place their orders through that same broker, so that the dealing commissions paid through the execution channel are used to compensate the broker for the whole suite of services. This tying together of execution with research and sales is called ‘bundling’. If a broker is the best service provider in sales and research as well as execution services, the bundling of these services may not give rise to issues. However, it is rarely the case that a single broker would offer best-inclass execution capabilities as well as research services across all asset classes, all sectors and all geographical regions. A  portfolio manager may therefore be incentivised to use a broker that has the best research in Vodafone shares but does not have the best execution capabilities in the UK where Vodafone shares are mostly traded. This means that the portfolio manager is not compliant with its obligation to choose the best execution provider for the purposes of the execution services and is therefore possibly defaulting on its duties to investors, a significant conflict of interest. 5.8 In addition, under the ‘bundled’ commissions model, there are no means of rewarding brokers for these research and sales services other than the dealing commissions produced by the execution of orders. Therefore, a portfolio manager may feel that it needs to place orders with the broker even if it does not need to, in order to provide the broker with adequate recompense for these services. There is therefore a risk of ‘portfolio churning’, ie  an unnecessary readjustment of the manager’s portfolio, which only takes place to generate executions, in order to reward the broker for research and sales services. 5.9 This in itself gives rise to another potential conflict of interest – the sting in the tail is that dealing commissions do not really get paid out of the portfolio manager’s pocket, but are levied against the investors, as a cost. Overtime, unnecessary dealing commissions levied for rewarding research and sales provision from brokers could erode the returns that the investors could have had on the portfolio managed by the portfolio manager. These frictional costs in aggregate over the years could be very meaningful and, levied against the portfolio, could have a negative impact on the overall performance of the portfolio. 64

Potential conflicts of interest 5.14 5.10 Furthermore, research and sales services may be important in the investment process by informing the decisions of portfolio managers, but portfolio managers should also have the ability to make decisions on their own considering that they are being rewarded by investors specifically for their investing acumen. An investor in a portfolio managed by a professional manager would normally already be paying a significant management fee for the services of the manager, normally levied annually as a percentage against the value of the portfolio. The idea that the investor is in addition subsidising the portfolio manager’s decision making process through frictional costs incurred each time the portfolio manager is adjusting the portfolio gives rise to questions of transparency and accountability. These costs are ultimately not fully visible and impact all investors in the portfolio without any distinction, and investors cannot hold the portfolio manager accountable. 5.11 Another issue relates to a portfolio manager with multiple portfolios (what are commonly called ‘strategies’). In theory a portfolio manager may use the execution revenues generated by one strategy to compensate a broker for the sales and research services it has provided in respect of another strategy. There is therefore another potential issue arising that relates to the conflict of interest between investors in different strategies of the same portfolio manager. 5.12 Finally, the range of services that have been reviewed are viewed as relevant to the investing process and therefore given a special status in regulation. Other services include corporate access (which is discussed further in para 5.47 below) and capital introduction. Both of these services are problematic in their own accord, but exist in the margins of the investing process. What if the services veered into less acceptable services, such as excessive client entertainment, payment for the portfolio manager’s technology infrastructure, their premises or other extraneous services? To bring up an extreme example, what about paying the portfolio manager’s dry-cleaning bill? This would definitely benefit the portfolio manager and would be greatly appreciated but it is not at all pertinent to the investing process. This may be a way for the broker of enticing the portfolio manager to do business with that broker, but of course is beyond the pale. 5.13 In summary, it has been demonstrated that dealing commissions can give rise at least to the following potential conflicts of interest for portfolio managers: • undermining their duty of best execution in favour of brokers who provide better research or sales; • undermining their duty to act in the best interests of their clients by churning the portfolio to generate dealing commissions needed to reward brokers; • using dealing commissions generated by one client of theirs to pay for research relevant to services provided in respect of another client’s portfolio; • using dealing commissions to receive services that are not core to the investing process; and • being paid by the clients for their services, whilst at the same time expecting most of their core services to be provided by their brokers and paid for by the clients, through opaque costs. 5.14 One can see why bundled dealing commissions have become the focal point of regulators trying to put some rules around their use. The question 65

5.15  Dealing commissions and the unbundling challenge became particularly vexed in Europe, especially in the last decade, after the UK regulators became focused in one of the peripheral services referred to above: corporate access. However, before venturing into the UK regime, it is worth looking at the US experience, where regulators have been pronouncing on this topic since the 1980s, thereby informing at a later stage the debate in Europe.

THE US EXPERIENCE: THE SOFT DOLLAR ‘SAFE HARBOR’ 5.15 Considering the US experience, where regulators have a long history of providing guidance on the series of conflicts identified in para 5.13 above, it is evident that regulators have focused on the following areas: •

which services could be eligible to be compensated by portfolio managers through the use of dealing commissions; and

•

how these dealing commissions can be generated, ie  what type of transactions are eligible.

5.16 Under Section 28(e) of the Securities Exchange Act 1934, managers are allowed to pay more than the lowest available commission if the money manager determines that the commission is reasonable in relation to the value of brokerage and research services provided. This is what is termed in the US as the ‘soft dollar safe harbor’. Conduct of the manager outside the safe harbor may constitute a breach of fiduciary duty as well as violation of the federal securities laws and state laws. 5.17 Brokers may be subject to liability for aiding and abetting violations by money managers where the broker pays for services that are not permitted by the Section 28(e) safe harbor. 5.18 Over the past 40 years, the SEC has issued several releases interpreting the Section 28(e) safe harbor. In 1986, the SEC issued guidance that provided a broad interpretation of what might constitute eligible brokerage and research products and services under Section 28(e), and introduced the concept of ‘mixed use’ items. In 1998, the SEC published a soft dollar practices report (the ‘Report’) which indicated that investment advisers took an overly broad view of the products and services that fall within the safe harbor. The Report detailed numerous cases where ‘administrative’ or ‘overhead’ goods and services (such as office rent, licensing fees, backup generators, office supplies, and legal and travel expenses) were improperly classified as eligible research under Section 28(e). In addition, the Report also noted that improvements in technology had led to difficulties in applying client commission standards. In 2006, the SEC published ‘Guidance Regarding Client Commission Practices Under Section 28(e) of the Securities Exchange Act of 1934’, Exchange Act Release No 54165 (18  July 2006) (the ‘Release’), which can be found at: www.sec.gov/rules/ interp/2006/34-54165.pdf [accessed 4 August 2021]. 5.19

The Release provides guidance on:

(1) the framework for analysing whether a particular service falls within the ‘brokerage and research services’ safe harbor; (2) the eligibility criteria for ‘research,; (3) the eligibility criteria for ‘brokerage’; and (4) the appropriate treatment of ‘mixed-use’ items. 66

The US experience: the soft dollar ‘safe harbor’ 5.22

Determining ‘eligible research services’ 5.20 The product or service must constitute ‘advice’, ‘analyses’ or ‘reports’: • advice, directly or through publications regarding the value of securities, advisability of investing in, purchasing, or selling securities, and availability of securities or purchasers or sellers of securities (in other words, sales services); and • analyses and reports regarding issuers, industries, securities, economic factors and trends, portfolio strategy and the performance of accounts (in other words, research). 5.21 The product or service must reflect ‘the expression of reasoning or knowledge’. This requirement precludes products and services with inherently tangible or physical attributes. 5.22 In terms of ‘eligible research’, the SEC has prescribed that it may only include general research, specialised publications, market research and trade analytics (see table Determining ‘eligible research’ below).

Determining ‘eligible research’ General research • Traditional research reports • Discussions with research analysts • Corporate access • Seminars or conferences that provide substantive content relating to issuers, industries or securities • Software that provides analyses of securities portfolios • Corporate governance research and corporate governance rating services on issuers • Consultants’ services that provide advice regarding portfolio strategy • Proxy services that transmit reports and analyses on issuers, securities and the advisability of investing in securities Specialised publications • Financial newsletters, financial and economic publications that are not targeted to a wide, public audience • Trade magazines and technical journals concerning specific industries or product lines that are marketed to and serve the interests of a narrow audience Market research • Software and other products that depend on market research to generate market research, including research on optimal execution venues and trading strategies • Advice from broker-dealers on order execution, including advice on execution strategies, market colour, and the availability of buyers and sellers (and software that provides those types of services) • Market data 67

5.23  Dealing commissions and the unbundling challenge •

Company financial data and economic data (such as unemployment and inflation rates or gross domestic product figures)

Trade analytics • Pre-trade and post-trade analytics (including analytics transmitted through order management systems) • Software that provides analyses of securities portfolios

5.23 By contrast, the SEC has been very clear in proscribing certain services as not eligible to qualify as research

Services ineligible for ‘research’ Inherently tangible products and services • Computer hardware, including terminals and computer accessories • Telecommunication lines, transatlantic cables and computer cables • Travel expenses, entertainment, and meals associated with meetings with analysts or corporate executives or with attending seminars • Membership dues and professional licensing fees Mass marketed publications and services • Periodicals, directories, magazines, government publications Office and administrative products and services • Office furniture and business supplies • Office rent • Marketing • Consultants’ services that provide advice relating to the managers’ internal management or operations • Salaries (including research staff) • Legal expenses • Accounting fees and software • Website design and email software and internet services • Personnel management • Utilities • Software to assist with administrative tasks • Equipment maintenance and repair services Proxy voting • Proxy products or services that handle the mechanical aspects of voting, such as casting, counting, recording and reporting votes • Proxy services that assist a money manager in deciding how to vote proxy ballots 68

The US experience: the soft dollar ‘safe harbor’ 5.29

Brokerage services 5.24 Products and services determined as eligible brokerage services include: • connectivity services between and among money managers, brokerdealers and other relevant parties (eg custodians); • dedicated lines between a broker-dealer and a money manager’s order management system or between a money manager and a broker-dealer’s trading desk; • message services used to transmit orders to broker-dealers for execution; • trading software such as order routing and algorithmic trading software and for transmitting orders to direct market access systems; and • post-trade services, such as matching of trade information, electronic confirmation systems and short-term custody systems. 5.25 Not eligible as brokerage services are: • compliance products and services; • services that analyse portfolio information to evaluate a portfolio manager’s fulfilment of their duty of best execution, to determine whether portfolio managers are overtrading securities, or to determine breaches of fiduciary duty; • any products that stress-test a portfolio under a variety of market conditions; • error correction trades or related services in connection with errors made by money managers; • long-term custody services and custodial recordkeeping (in contrast to short-term custody); • trade financing, ie the payment of stock lending fees, capital introduction and margin services. 5.26 In November 2009, the Financial Industry Regulatory Authority (FINRA) alleged that Terra Nova Financial made more than US$1m in improper soft dollar payments without receiving adequate documentation or conducting an adequate review to determine that the payments were for expenses authorised by fund documents. These payments were made in respect of trips by hedge fund managers to a ‘gentlemen’s club’, credit card bills that contained charges for meals, clothing, auto repairs and parking tickets. As a consequence, Terra Nova Financial was fined US$400,000. 5.27 The term ‘soft dollars’ in the US is synonymous in Europe with dealing commissions which are used for the purchase of eligible research and brokerage services, outside pure execution.

Agency and riskless principal transactions 5.28 US regulators have also turned their attention to the types of transactions which may generate soft dollars, as the source of the funds may itself give rise to a conflict of interest. 5.29 In general, only agency transactions may generate dealing commissions eligible for use. In agency transactions, a firm executes for third-party buyer 69

5.30  Dealing commissions and the unbundling challenge and sellers and charges a commission. In principal transactions, a firm acts as a counterparty to its client and buys or sells securities to the client, charging a spread (ie a mark-up or mark-down to make money versus the price at which it sourced the securities). In the US, soft dollar credits cannot be generated where the broker dealer has acted as a principal to the transaction. This goes to the fundamental point that the portfolio manager would be incentivised to send their business to that particular dealer whilst getting the benefit of soft commissions, without applying the necessary scrutiny to the transaction as to whether it was reasonably executed or not. There would be no certainty as to whether the portfolio manager received the best price. The authorities in the US have therefore been conservative in respect of the capacity in which the broker dealer acts to generate eligible commissions. No such restriction currently exists in the UK and the EU.

Commission sharing arrangements and third-party research 5.30 To provide additional flexibility to portfolio managers in choosing research providers that are not tied to the brokers executing the trade (thereby addressing one of the fundamental conflicts identified earlier), the SEC has provided interpretative relief that assists managers and brokers to purchase services from third-party brokers using dealing commissions generated by the broker. 5.31 Section 28(e) requires that research be ‘provided by’ a broker-dealer involved in ‘effecting’ the trade. In third-party arrangements, investment advisers obtain research services and products developed by someone other than the broker-dealers effecting the transaction. The SEC has provided additional guidance on the terms ‘effecting’ and ‘provided by’ as used in this context: •

Broker-dealers are ‘effecting’ the trade if they execute, clear or settle the trade, or perform one of four functions (taking financial responsibility for customer trades, maintaining records relating to customer trades, monitoring and responding to customer comments concerning the trading process, and monitoring trade settlements) and allocate the other functions to another broker-dealer.

•

Broker-dealers ‘provide’ the research if they (a) prepare the research, (b) are financially obligated to pay for the research, or (c) are not financially obligated to pay for the research but take steps to ensure that the commissions paid are used only for eligible brokerage and research.

5.32 This has allowed for the development of what are called commission sharing arrangements under which the broker is collecting dealing commission credits for the portfolio manager, as the portfolio manager executes through that broker, which then the portfolio manager can ‘spend’. They spend these dealing commissions credits, by instructing the broker to pay the third-party providers or – if the portfolio manager consumes research from that broker’s research department – instructs the broker to retain some of those commissions for its own services. In the US, these arrangements are called client commission agreements (CCAs), and in Europe they are called commission sharing agreements (CSAs). They became very popular in the first decade of the 2000s and are still in use in the US. Their key features are: 70

The US influence on the UK experience 5.38 • • • •

a quarterly reconciliation of the dealing commissions generated – the client and the manager have to agree how many transactions are agency/ riskless principal to benefit from the safe harbor; a process by which the client places instructions to the broker on an annual or semi-annual basis to pay for research services; a statement of compliance by the portfolio manager on the procurement of services from research providers benefiting from the Section 28(e) safe harbor in respect of research services; and a disclaimer of liability by the broker on the relevant choices made by the portfolio manager.

5.33 The proliferation of these agreements, especially in the US, have helped to distinguish those brokers who offer better execution services, as they could continue providing these services even without a similar quality of services provided through their research department. 5.34 A  key element of these arrangements in the US is that the portfolio manager seeks to evaluate the research it has received in the preceding year before deciding what to pay each of its providers. This became the international practice until it was challenged in Europe by MiFID II.

THE US INFLUENCE ON THE UK EXPERIENCE 5.35 The UK was the first European jurisdiction to follow in the footsteps of the US and to create explicit rules regarding the use of dealing commissions. Prior to 2006, bundled dealing commissions were used to pay for a variety of goods and services. In 2006, the Financial Services Authority (FSA) unbundling regime was introduced in the UK Conduct of Business Sourcebook (COBS). In COBS 11.6, the FSA required of UK investment managers that only execution and research services could be paid out of dealing commissions. 5.36 The FSA, in a similar fashion to SEC, gave a list of the types of services that would qualify as a research service and the types of services that would qualify as execution services. Research was required to: • be capable of adding value to the investment or trading decisions by providing new insights that inform the investment manager when making such decisions about its customers’ portfolios; • represent original thought, whatever form its output takes, in the critical and careful consideration and assessment of new and existing facts, and not merely repeat or repackage what has been presented before; • have intellectual rigour and not merely state what is commonplace or selfevident; and • involve analysis or manipulation of data to reach meaningful conclusions. 5.37 So far, the UK looked to be closely mapping the perimeter of what was considered research by the SEC. 5.38 However, the devil was in the detail of the exclusions. The FSA, much like the SEC, gave examples of goods or services that relate to the provision of research that the FSA does not regard as meeting the requirements of the rule on use of dealing commission. Those included price feeds or historical price data 71

5.39  Dealing commissions and the unbundling challenge that have not been analysed or manipulated to reach meaningful conclusions. By contrast market data and economic data, even without further analysis, would qualify as research under the US test. 5.39 In terms of execution commissions (what the US termed ‘brokerage services’) the UK was again stricter. On the face of it there were several similarities. The FSA explicitly prohibited: • computer hardware; • connectivity services such as electronic networks and dedicated telephone lines; • seminar fees; • subscriptions for publications; • travel, accommodation or entertainment costs; • order and execution management systems; • office administrative computer software, such as word processing or accounting programmes; • membership fees to professional associations; • purchase or rental of standard office equipment or ancillary facilities; • employees’ salaries; • direct money payments; • publicly available information; and • custody services 5.40 Amongst this list, the most problematic case was the reference to order and execution management systems. These are systems that normally reside in the technology infrastructure of the portfolio manager. They determine the logistics whereby orders are directed (routed) to one or more brokers and often host algorithms that can be used to achieve more efficient execution. These systems are developed by technology firms and are provided to portfolio managers for a licence fee. Having the broker pay for that licence and then expecting to be compensated by the portfolio manager through dealing commissions for the offering of the service presented regulators with a clear conflict of interest. The system paid for by the broker determines which broker is chosen in each execution and can only exist in the terminal of the portfolio manager if the broker is compensated enough through dealing commissions (ie executions) to pay for it. It is therefore sensible that the UK regulators included this on the prohibited list. However, such systems were explicitly allowed under the SEC guidance regarding the Section 28(e) safe harbor. 5.41 These dissimilarities created an uncomfortable situation for global portfolio managers who tried to run businesses in a harmonised way, sometimes consuming research in their New York or Boston offices and then executing trades in European securities out of their UK affiliates. Several of the problematic provisions were therefore glossed over by practice. The order management system issue was considered too sensitive to broach and, often portfolio managers, including significant ones, would expect such a service by their broker. 5.42 Similarly, the service of ‘corporate access’, as discussed in para 5.47 below, is referenced in the US rules explicitly as permitted under research services. The UK authorities had not originally mentioned it in the list of prohibited services as non-eligible for research, even though they must have 72

The corporate access debate 5.47 been aware of the US reference to it. For several years, it continued to be paid out of dealing commissions in the UK as a research service. As it happens, corporate access was the beginning of the undoing of this regime in the UK and Europe, as will be seen in para 5.47. 5.43 In November 2007, MiFID  I  was implemented in the EU. There was no harmonisation on dealing commissions and there was only a general inducements regime available in MiFID  I. The UK retained its pre-existing regime and notified these requirements as one of the areas of gold-plating of MiFID I under Article 4.

THE CHANGE OF THE TIDE IN EUROPE 5.44 In November 2012, the FSA published a ‘Dear CEO’ letter, summarising findings from their thematic review on ‘Conflicts of interest between portfolio managers and their customers’ concluding that some firms were paying for services which were not ‘research’ out of dealing commissions. The FSA’s line of attack was that the arrangements did not serve the underlying best interests of clients. End customers were paying for things they should not. In addition, clients were paying too much for things they should pay for. Ineligible costs and core costs were both being subsidised. The FSA’s thesis was that buy-side and sell-side had constructed a system that inflated their profits at the expense of investor returns. 5.45 More importantly, they raised concerns regarding the level of research commissions that so linearly tracked trading volumes. Did that indicate ‘portfolio churning’? 5.46 For the first time, they expressly frowned upon the use of dealing commissions by portfolio managers for corporate access. By contrast, in 2006, the SEC explicitly stated that ‘meetings with corporate executives to obtain oral reports on the performance of a company’ qualified as research services under the Section 28(e) safe harbor.

THE CORPORATE ACCESS DEBATE 5.47 In March 2013, Robert Peston, the celebrated financial journalist who at the time worked for the BBC, published an article called ‘Pimp my CEO’. He wrote: ‘If company chief executives are being pimped out by brokers to fund managers … it is clear to me that the CEOs themselves (well, the ones I’ve spoken to) are innocent victims (as it were). Here is how one CEO put it to me: “Why would they want to pay money to a broker for access to me? If they are a credible institution, all they have to do is ring up my investor relations department and of course I will meet them. I would be a fool to do otherwise.”’ (www.bbc.co.uk/news/business-21668378) A reference to this issue in mainstream media and the continuous publicity that followed in the financial press spurred on the FCA to proceed with reviewing the arrangements on corporate access. 73

5.48  Dealing commissions and the unbundling challenge

What is corporate access? 5.48 Corporate access is defined as a service provided by brokers to portfolio managers, facilitating their investment decision process through contact with the management of companies. It may include one-on-one meetings, non-deal roadshows, field trips, or conferences. The interaction often involves research input by the broker as an adjunct to the meeting. But ultimately, this is a ‘dating’ service provided by brokers to their clients, portfolio managers and corporations alike. In fact, several portfolio managers considered that service more valuable than independent research itself and paid for it explicitly as the only service they cared about. However, even in 2014, the idea that corporate access qualified as research or eligible for payment through dealing commissions was not particularly credible. This is because the UK regulator already had in place since 2006 the aforementioned rules regarding the use of dealing commissions, which required portfolio managers to only apply dealing commissions for the consumption of research services if this involved the manipulation of data for the provision of meaningful conclusions.

Corporate access prohibition in 2014 5.49 In October 2013, Martin Wheatley (then the Chief Executive of the FCA) announced a renewed focus on dealing commissions, aiming to improve transparency, to ban the payment of corporate access through dealing commissions, and acknowledging the need for international cooperation considering the global nature of the industry. The FCA then launched a consultation on these themes (CP13/17) looking to effect change in the use of dealing commissions for corporate access. 5.50 As a result of that consultation, in 2014 the FCA changed the rules, defining for the first time corporate access as a service of arranging or bringing about contact between an investment manager and an issuer or potential issuer. The FCA then included the service in the list of prohibited services. 5.51 The FCA introduced a requirement for investment managers to disaggregate the services when they are provided on a combined basis. COBS 11.6.8A states that: ‘Where a good or service received by an investment manager comprises the provision of substantive research together with elements that are not substantive research, […] the investment manager should disaggregate any such good or service received, to ensure that it only accepts the substantive research elements [under the dealing commission rule].’ 5.52 But then, the level of ambition of the FCA was such that a win in the corporate access debate was not going to be the end of that process. On 10 July 2014, the FCA expressed its preference for full unbundling. In other words, research itself should not be payable at all out of dealing commissions. Dealing commissions should only be used for execution services with portfolio managers paying for research out of their own pocket. 5.53 It consulted on two options: Under option 1, only broadly disseminated research could be paid out of dealing commissions. Bespoke research services were to be paid by the portfolio managers themselves. Under option 2, all research services were to be paid out of the managers’ own resources. This 74

The MiFID II regime 5.55 set the stage for the FCA to take the fight to Europe and insert their proposed reform in the MiFID II draft legislative text. Instead of concluding a rule-making process in the UK, it took the results of this consultation and fed it into the MiFID II legislative process. 5.54 This development was rather unexpected by other regulators in Europe, such as the AMF in France. In the months that followed, until 2016, the topic was hotly debated in ESMA, with the FCA managing to convince other regulators to introduce a level of unbundling in European legislation, without insisting that the money has to come exclusively from the resources of the portfolio managers.

Figure 5.2  Dealing commissions unbundling – a timeline

THE MIFID II REGIME 5.55 Under Articles  24(7)(b) and 24(8) of MiFID II, a portfolio manager regulated under MiFID or an independent investment advisor is ‘not permitted to accept fees, commission or any monetary or non-monetary benefits from third parties in relation to the provision of services to clients’. The provision aims to address the conflict identified in para 5.6 above between the managers’ duty of best execution and the choices they may make if induced by extraneous benefits. 75

5.56  Dealing commissions and the unbundling challenge 5.56 Unsurprisingly, some small exceptions were made for what were termed ‘minor non-monetary benefits’, although these benefits constitute a finite list and are genuinely unimportant. They include: • generic information on financial instruments or investment services (such as prospectuses, or promotional material); • written material from a third party that is commissioned and paid for by a corporate issuer or potential issuer to promote a new issuance by the company, or where the third-party firm is contractually engaged and paid for by the issuer to produce such material on an on-going basis, provided that the relationship is clearly disclosed in the material and that the material is made available at the same time to any firms wishing to receive it, or to the general public; • participation in conferences, seminars and other training events on the benefits and features of a specific financial instrument or an investment service; and • hospitality of a reasonable de minimis value, such as food and drink during a business meeting or a conference, seminar or other training events.

Payment mechanism 5.57 In order for investment research not to constitute an inducement, the investment firm must pay for the research directly with its own funds or pay for such research from a designated research payment account funded by specific charges to its clients. That is, brokers could no longer use dealing commissions to be compensated for both execution fees and research costs. With MiFID II, dealing commissions were strictly going to be used only for execution fees. 5.58 Article  13(1) of Directive EU/2017/593 (the ‘MiFID  Delegated Directive’) provides that the provision of investment research by third parties (eg  brokers) to portfolio managers shall not constitute an inducement if the research is received in return for any of the following: • direct payments by the investment firm out of its own resources; or • payments from a separate research payment account (RPA) controlled by the investment firm. 5.59 These requirements have been implemented in the UK in COBS 2.3B. A  portfolio manager may therefore obtain research from third parties either where it pays for it directly from its own funds, or where the research is paid for from an RPA that complies with all of the necessary conditions. Where an investment firm uses an RPA, the Delegated Directive requires that: • the RPA must be funded by a specific research charge to the investing client (which must not be linked to the volume/value of transactions executed on behalf of clients); • the portfolio manager must set up and regularly assess a research budget which must be agreed with clients; • the investment firm must regularly assess the quality of research purchased and its ability to contribute to better investment decisions; and • the investment firm must provide to its clients detailed information about the arrangements with its providers. 5.60 76

In response to these requirements, two types of RPAs emerged:

The MiFID II regime 5.65 (1) The ‘accounting method’, otherwise known also as the Swedish model as it was first adopted by Swedish portfolio managers. According to these arrangements, the portfolio manager levies a direct charge of a pre-agreed size onto the fund investors on an annual basis, explicitly for the purchase of research services. (2) The ‘transactional method’, pursuant to which a research charge is collected alongside the brokerage commission, feeding over time the research payment account. This arrangement is governed by a new type of agreement between a portfolio manager and its respective brokers, called research charge collection agreement, or RCCA. The RCCA has now replaced the pre-MiFID II CSAs, in all cases where the client is a MiFID II portfolio manager or investment adviser, or subject to these rules by virtue of national implementation (eg, UK hedge funds). 5.61 The use of an RCCA allows for some continuation of use of dealing commissions, but these are now re-characterised as research charges levied on the transactions which generate a sum used to pay a variety of providers regularly. After the RRCA funds are swept by the brokers into the portfolio manager’s research payment account, the funds are then used to pay the research providers. 5.62 The MiFID Delegated Directive also requires that portfolio managers must have a written policy in respect of investment research and provide it to clients. The policy must cover the following issues: • the extent to which research purchased through the RPA may benefit clients’ portfolios including, where relevant, consideration of the investment strategies applicable to the various types of portfolios; and • the ‘approach the firm will take to allocate such costs fairly to the various clients’ portfolios.’

The brokers’ obligations 5.63 Specific obligations also apply to the sell-side under the MiFID Delegated Directive, particularly under Article 13(9), which requires in effect that: • EU brokers identify separate charges for their execution services that only reflect the cost of executing the transaction; • any other benefits or services provided by the broker to EU investment firms are subject to a separately identifiable charge; and • the supply of those benefits and services and charges for them shall not be influenced or conditioned by the levels of payment for execution services. 5.64 These requirements have been implemented in the UK in COBS 2.3C. A consequence of the way the rules are drafted (focusing on the portfolio manager rather than the broker) is that the requirement to price research services applies to EU brokers only in respect of their business with EU portfolio managers; EU brokers are not required to provide such pricing information when providing research to non-EU investment managers. 5.65 However, in truth, the portfolio management business is globalised and therefore it is hard to distinguish between the locations in which the portfolio manager is consuming the research and out of which legal entities. Often a 77

5.66  Dealing commissions and the unbundling challenge portfolio manager in the UK, who would be squarely within the scope of the rules, will have delegated some of its functions to its affiliated US portfolio manager (eg portfolio management decisions relating to US markets). By virtue of the fact that the UK entity is in scope of paying for the research consumed, certain overseas individuals’ consumption of research may also be in scope. This issue is particularly important as the level of consumption could of course influence the level at which the research services are priced. This does hint at an extraterritorial impact of MiFID II in terms of pricing. In respect of how a broker could price research proactively, creating a commoditised product for the first time, the principles of such pricing are examined in para 5.69 below.

THE CONFLICT OF LAWS ARISING BETWEEN THE US AND EU REGIMES 5.66 The conflict of laws arising from this rule between the US and EU regimes has been a difficult battleground for regulators. First, the ability of a portfolio manager to pay out of its own resources, in what the industry calls ‘hard dollars’ (by contrast to the ‘soft dollars’ discussed in para  5.16 above), means that the broker should have the ability to receive such payment. This is not an issue if an EU portfolio manager pays an EU broker. However, it becomes an issue if an EU portfolio manager attempts to pay a US broker, or, even possibly, the EU affiliate of the US broker. 5.67 US brokers are not allowed to receive hard dollar payments unless they are registered as investment advisors under the Investment Advisor Act of 1940. Although this is possible, it brings with it requirements of segregation of sales and execution functions which are nearly impossible for a broker. So brokers would generally not choose to register as an investment advisor. As this is a feature of US regulation and MiFID II is not forcing US brokers to receive hard dollar payments, one may think that this should not really be an issue. On the contrary, the globalisation of the portfolio management industry meant that portfolio managers had to apply the MiFID II requirements across their entire affiliate network and therefore sought to follow these requirements in the US, where following them would have created an impossible situation for the US brokers. 5.68 After significant debate between the SEC and ESMA as to which of the two jurisdictions needed to adjust their rules to solve the issue, the SEC gave, on 26  October 2017, at the last minute, exemptive relief to US brokers in respect of payments received in connection with this MiFID II rule (www. sec.gov/divisions/investment/noaction/2017/sifma-102617-202a.htm [accessed 4 August 2021]). This exemptive relief allowed brokers to receive hard dollar payments, as long as they were in connection with the relevant rule in MiFID II, without the need to register as an investment advisor. It also recognised that the MiFID II rule may be gold plated in certain jurisdictions, so it allowed the same exemption for business related to alternative investment managers (hedge funds) with presence in the UK, as the UK had decided to expand the application of the rules to these entities, even though they fell outside the scope of the MiFID II requirement. The US exemptive relief was provided on a time-limited two-year basis in the first instance, although eventually it was renewed for another three years until 3  July 2023 (www.sec.gov/news/press-release/2019-229 [accessed 4 August 2021]). 78

Practical guide: how does a firm price research? 5.70

PRACTICAL GUIDE: HOW DOES A FIRM PRICE RESEARCH OR OTHER SERVICES TO AVOID BEING CLASSIFIED AS AN INDUCEMENT? 5.69 As mentioned above in para 5.30, a firm would normally be receptive to the evaluation of its research services from clients after the provision and essentially would be a ‘price taker’ from clients. After the end of a period, possibly as long as a whole financial year, the client would evaluate the quality and quantity of the research looking back at the experience they had with that broker (comparatively to other research providers) and would determine the exact monetary value that the service was worth to them. This ex-post assessment and payment practice was universal for the unbundled services that portfolio managers received under the CSA/CCA arrangements through the SEC and the old FSA regime. However, post-MiFID II, EU portfolio managers could no longer follow this process, as they now had to receive an ex-ante estimate of how much the research would cost them in the following year and agree that with the brokers. This put pressure on EU brokers to create a pricing methodology for their product and to communicate this to their client base – an unprecedented process across the entire finance industry. As with all pricing processes coming about without any information points on the competitive landscape, this gave rise to significant challenges for brokers.

Pricing principles 5.70 Set out below is a practical guide on arriving at a price without breaching the fundamental requirements of the regulation. The broker needs to first establish some pricing principles to ensure that the way it approaches pricing its research or any other non-execution service does not result in an allegation of providing inducements to trade. These pricing principles should be followed specifically when a firm is pricing services provided to clients who themselves are investment firms regulated as portfolio managers under MiFID II. Such clients are required by MiFID II and domestic implementing laws to pay separately for research or other services from execution payments (‘in-scope clients’). To avoid giving rise to inducements issues, firms need to keep the following principles in mind: • No research price can be influenced or conditioned by levels of payment for execution services. This regulatory requirement underpins not only initial pricing but also the future evolution of the price of research. • Clients must be treated fairly. There is no obligation to offer the same price to every client for access to research content and services. However, research pricing should be based on objective criteria and the broker should not seek to price research through illegal or unethical business practices or on the basis of misrepresented material facts. • Some research materials can be provided for free as a minor non-monetary benefit. Following the MiFID II implementation, the FCA gave guidance that it would consider openly available research as being treated as minor non-monetary benefit. Issuer-sponsored material would also be acceptable as minor non-monetary benefit. Some brokers opted to provide their product without a charge under this principle by hosting it on their website, rather than an exclusive client portal. For a website to qualify as open access, there should not normally be any sign-up requirements. 79

5.73  Dealing commissions and the unbundling challenge •

•

Research (other than the de minimis content in the previous bullet point) can be provided for free for limited trial periods. The principle of free trials has to be applied reasonably and in line with ESMA’s guidance: – there is a maximum time limit of three months; – no payment or non-monetary benefit may be received for the research during the trial; – no new trial may be commenced within 12 months of the end of any previous research paying arrangement or free trial; – the trial period must be offered and agreed upon prior to the decision to enter into a paying research subscription; – the scope and extent of research offered during the trial must be agreed by both parties in advance of the trial; and – the prohibition on the broker receiving any benefits during the trial period includes implicit benefits such as abnormally high order flows from the portfolio manager compared to volumes normally carried out with the broker or its affiliates. The provision of research cannot be made at a price that evidently is below the cost of the production incurred by the firm. In other words, there is an explicit requirement not to provide research at undervalue, as in such cases there is a presumption that the product is provided as a bonus to the client with the expectation of the client recompensing the firm through channelling increased trading volume.

How does a firm determine the initial price? 5.73 It is important to highlight that financial regulation in Europe does not seek to stipulate or regulate prices and as such the decision on pricing rests entirely with each market participant and the forces of competition. However, the provision of services at undervalue by one part of a complex firm could be evidence that the firm expects to make up the difference through incentivising the client to spend more in another part of the firm. One could argue that there should be nothing wrong with that. Even supermarkets have so called ‘lossleading’ items, like milk or other basic goods, in the hope that the customer will be attracted to the supermarket in the first place and subsequently spend more on high value items where the supermarket stands to make wider margins of profit, outstripping any loss it may have made on the loss leader. 5.74 However, regulators are suspicious that this overprovision of free benefits clouds the judgment of portfolio managers in choosing a broker for the core service of execution (the high value part of a broker’s business) irrespective of the quality of execution they receive. And at the end of the day, even if consumers at a supermarket have only themselves to blame for being lured into the trap of spending more on high value items, portfolio managers have underlying clients that bear the cost of their bad decisions. These underlying clients can be ordinary investors that have no control or transparency over these practices. 5.75 Regulators therefore look at promotions of that nature, ie  provision of services at undervalue as very strong evidence of cross-subsidisation of the businesses of a complex firm and therefore possible inducements. To begin a process of determining the price of research, the risk of undervaluing has to 80

Life since MiFID II 5.79 be avoided, by calculating the all-in cost of producing the research and then dividing it between clients, to establish a floor below which the research price should not fall, at least not habitually. 5.76 Following the establishment of a price floor, brokers can impose additional profit margins which they can adjust depending on the client. They may be able to provide a discount to larger clients by reference to their overall consumption of research (not execution) services. They may also apply significantly discounted rates to clients that are particularly focused on a narrow asset class and consume a small selection of reports annually. In all cases, discounts should not fall below the floor for long periods and should be flexed within predetermined parameters, eg a specific percentage range.

LIFE SINCE MIFID II 5.77 Global portfolio managers have now largely adjusted to arrangements that are based on MiFID II for most locations in the world based on the development on new charging structures and the use of either own funds or explicitly charged research charges paid for by investors. This exportation of regulation by the EU has not been without controversy but has forced a higher level of transparency and accountability. 5.78 It has also brought about a rationalisation of research provision and a greater concentration of research resources with those providers that were of higher quality. Several brokers have reduced the size of their research departments, responding to decline in demand. 5.79 Equally, those brokers that had stronger execution capabilities consolidated their position further by attracting portfolio managers as clients who previously were perversely incentivised to use their research brokers. The increase in quality of execution has ultimately benefited the end investor.

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6 Multilateral and bilateral trading systems

This chapter will cover: • the concept of broker crossing networks and the features that distinguish them from exchanges as forms of multilateral trading; • the differences between multilateral trading and bilateral trading, including where the latter is deemed as systematic internalisation; • the use of discretion as a key feature of BCNs and OTFs as opposed to other trading venues; • the need for pre-transparency to have effective price formation, subject to a limited use of pre-trade transparency waivers to create more flexibility; and • the constraints that have been imposed under MiFID II on systematic internalisers and MTFs and recent regulatory policy that may influence their further evolution 6.1 When one contemplates the differences between the role of brokers and that of trading venues, the differences are not always particularly pronounced; the two functions sit instead on a spectrum. On the one end, there is the advancement of capital by a dealer when they decide to provide prices to their clients in instruments that are possibly illiquid; such advancement of capital could never be provided by a trading venue itself as venues are required to match trading interests and not take part in the action themselves. Venues at their most basic should at least be matching a dealer with multiple clients, without the venue ever assuming any risk itself. Alternatively, and more commonly, venues match multiple participants in a system within specific pre-set parameters.

BROKER CROSSING NETWORKS 6.2 If one tried to identify where the two ends of the spectrum begin to blend into a hybrid in the middle, this would be found in functionalities introduced by brokers. In a style not that dissimilar to that of a venue, brokers may try to match their clients together rather than advance principal liquidity, especially when executing orders in the more liquid asset classes, such as shares. This activity brings certain benefits to the clients who would normally prefer to be matched with other sellers and buyers in the market, thereby accessing what is often called ‘natural liquidity’. The benefits of natural liquidity are drawn from the fact that both sides of the trade have a genuine need to buy and sell these securities. A client with a genuine trading interest that wants to sell some of its securities in a particular stock would not want to see the price of the stock plummet after they 83

6.3  Multilateral and bilateral trading systems have sold their position, as they may have further securities of the same stock that would depreciate automatically. If, on the other hand, a genuine buyer that wants to invest long-term in that stock turns up and offers to buy the position, this would ensure that the price of the stock will not be affected, as the new purchaser will not buy with a view to selling opportunistically, to make a quick profit. By contrast, there are market making firms whose sole purpose is to make intraday profits by arbitraging price differences in the same security across different venues. Many investors with long-term investment strategies do not want to interact with this type of market making firm. Market makers are prevalent on exchanges, so it is natural that certain investors (who are clients of brokers) want to avoid having their order exposed on the exchange and would instead prefer if the broker matched them with another ‘real’ investor, who represents natural liquidity. A  broker that matches buying and selling interests between its clients systematically may be viewed as running a broker crossing network (BCN). A BCN is often called a private pool of liquidity, as it is only available to the clients of the broker (no other external participants) and the broker can reject any entity/person who would like to become their client, without having to provide any justification. This discretion exercised by the broker over the entrance criteria has given rise to criticism that brokers run venues that are in direct competition with exchanges without the same level of public access and supervisory scrutiny. 6.3 On the other hand, exchanges have welcomed with open arms the systematic market making participants who do not represent natural liquidity but trade often and in small sizes. This market-making community, often generally called the high frequency trading (HFT) community, provides some benefits to the market, as it is always available to trade (an important benefit when there are only few natural participants) and also helps reduce the bid-offer spreads by trading across markets in the same securities systematically and arbitraging any gaps identified. However, their readiness to buy and sell the same security repeatedly with a view to making small but continuous profits has resulted in that flow being viewed as ‘toxic’. It has therefore been a natural consequence that BCNs were often assessed by the longer-term investing clients of the brokers in respect of their toxicity, ie the presence of market-making flow in the mix of clients of the broker. Some brokers would never enable HFT firms as clients in their BCNs to preserve the BCN from any hint of toxicity, whereas others allowed some level of HFT activity to improve the hit-rate in their BCN (the likelihood of execution), whilst compromising on toxicity. 6.4 In 2016, the Securities and Exchanges Commission in the US and the New York Attorney General announced two significant fines against Barclays Capital Inc. and Credit Suisse Securities (USA) LLC for several violations of federal securities laws while operating dark pools: see www.sec.gov/news/ pressrelease/2016-16.html [accessed 4 August 2021]. Most of the violations had to do with the description of the functionality in the dark pools operated by the two firms. In both cases, they had sought to reassure their clients that they would be shielded from clients that could be categorised as HFT, whereas they had failed to do so. Barclays said that a feature called Liquidity Profiling would ‘continuously police’ order flow in its LX dark pool and that the firm would run ‘surveillance reports every week’ for toxic order flow. In fact, Barclays did not continuously police LX for predatory trading using the tools it said it would, and it also did not run weekly surveillance reports. Barclays did not adequately disclose that it sometimes overrode Liquidity Profiling by moving some subscribers from the most aggressive categories to the least aggressive. 84

Bilateral trading and systematic internalisation 6.7 The result was that subscribers that elected to block trading against aggressive subscribers nonetheless continued to interact with them. Credit Suisse misrepresented that its Crossfinder dark pool used a feature called Alpha Scoring to characterise subscriber order flow monthly in an objective and transparent manner. In fact, Alpha Scoring included significant subjective elements, was not transparent, and did not categorise all subscribers on a monthly basis. Credit Suisse misrepresented that it would use Alpha Scoring to identify ‘opportunistic’ traders and kick them out of its electronic communications network, Light Pool. In fact, Alpha Scoring was not used for the first year that Light Pool was operational. Also, a subscriber who scored ‘opportunistic’ could continue to trade using other system IDs, and direct subscribers were given the opportunity to resume trading. These cases demonstrate the reliance that clients place on brokers operating BCNs to protect their interests and the legitimate expectation that is created when brokers provide commitments in that regard. 6.5 In Europe, the rise of BCNs in the 2010s brought them to the attention of legislators who began looking at the arguments in favour and against them in the course of the MiFID review that led to MiFID II: Arguments in favour of BCNs

Arguments against BCNs

Confidentiality of orders, even though still subject to post-trade transparency

No pre-trade transparency, so little contribution to price formation

Control of counterparties, so that opportunistic strategies are not prevalent

Not available to everyone (no open access requirement)

Discretionary: broker can set the rules that allow interaction

Discretionary: broker maintains ownership of the criteria that allow flows to interact and at what price points: not public and not immutable

Broker, clearing and execution (B, C & E) costs are lower

Misses out on available liquidity on exchanges

Rules still governed by best execution

Looks very much like an exchange but not regulated as such, with the higher standards of exchanges

6.6 This debate raged for several years and led to some drastic rethinking by legislators in Europe of what should be the activity which is the preserve of brokers versus that of multilateral venues, as we will see in para 6.18 below.

BILATERAL TRADING AND SYSTEMATIC INTERNALISATION 6.7 If brokers act more like exchanges in running BCNs, they are – by contrast – performing their most essential function by dealing in financial instruments as a principal with their clients. Dealing in financial instruments means that the customer expects the investment firm (in this case acting as a dealer) to advance liquidity and does not expect exposure to the market. This means that the dealer’s obligations and the client’s expectations are very different to when a client expects a firm to act as a broker. Dealing as principal against a client is called in MiFID ‘dealing on own account, when executing client orders’, as seen in para 3.16 above. In other words, the dealer is not expected to place the client’s order on a venue. Instead the dealer will fill the client’s order 85

6.8  Multilateral and bilateral trading systems from existing inventory. Ultimately, for instruments that are traded on venue, the dealer will perform some activity on the exchanges and MTFs in advance of receiving a client order or after the receipt of that order, to be able to manage its own inventory and to be ready to satisfy on-going client demand. That activity is not however in direct one-to-one corelation to a client’s order, which explains why the firm is not viewed as executing the client’s order on the venue. 6.8 The client therefore has an expectation when transacting with a dealer that the dealer’s activity on the market (what is called the street-side) will not be such that it reveals too much about the OTC activity of the client. The client also has a very clear settlement expectation against the dealer which means that any failure by the dealer will be solely ascribable to the dealer as its own liability. By contrast when the firm acts as a broker, the client and the broker agree that the client has exposure to any settlement failures that may occur on the market side. This fundamental exposure of a client to the dealer in bilateral transactions means that OTC trading is viewed as of higher risk for clients and firms alike. 6.9 MiFID  I  recognised the concept that clients trade over the counter (OTC) with dealers and – as it was not something that the authorities wanted to promote – they tried to limit it to ad hoc and irregular interactions. That distinction between ad hoc and systematic had already been introduced for equities in MiFID I and was expanded to more asset classes (anything traded on a trading venue) in MiFID II. The way to limit the presence of OTC trading was to create a particular regulatory category called ‘systematic internaliser’ for instances where OTC trading became significant and systematic. Article  4(1) (20) of MiFID II defines ‘systematic internaliser’ as: ‘an investment firm which, on an organised, frequent systematic and substantial basis, deals on own account when executing client orders outside a regulated market, an MTF or an OTF without operating a multilateral system’. Being categorised as a systematic internaliser or SI brought with it several obligations that were not inherent in OTC trading, most importantly pre-trade transparency. There are two types of SIs, with somewhat different obligations, depending on whether they trade shares or non-equities. These obligations will be examined further below. 6.10 The wording ‘without operating a multilateral system’ in the definition of systematic internaliser is key. A multilateral system is defined in Article 4(1) (19) of MiFID II: ‘“multilateral system” means any system or facility in which multiple thirdparty buying and selling trading interests in financial instruments are able to interact in the system.’ This established the first major fault line in the categorisation of trading systems: multilateral versus bilateral. All business initiatives launched within the construct of a systematic internaliser have to be examined from that perspective, to ensure that they do not introduce multilateral trading functionality, as that would be impermissible within the systematic internaliser. Systematic internalisers must never accept client orders in shares with a view to crossing them with other client orders in shares. There are ways, however, in which a systematic internaliser can advance principal liquidity of the firm, originating from hedges to client derivatives, so that this principal liquidity could be advanced to clients trading shares. 86

MTFs and regulated markets 6.13

MTFS AND REGULATED MARKETS 6.11 As an alternative to regulated markets, MiFID I had already introduced MTFs as a form of multilateral trading venue to mirror the ATS venues in the United States. The idea was that an MTF would behave like a mini exchange but didn’t have the status of a regulated market as one could not list securities on MTFs. All initial public offerings would normally be launched on a regulated market, as exchanges are called under MiFID. To introduce competition and to allow the creation of markets where securities from all over the EU could be traded in one place, the concept of the MTF was introduced. That was a significant step towards the creation of a single market in financial services in the EU. Although MTFs could be viewed as competitors to the regulated markets when they launched, most operators of regulated markets found the concept of an MTF appealing as it allowed them to trade instruments that were not listed on their regulated markets and therefore expand their offering. Therefore, many regulated market operators now own separate MTFs within the group of companies that operate the relevant regulated market; for instance Turquoise is part of the LSE Group, with Turquoise being used for pan-European shares. 6.12

An MTF is defined in Article 4(1)(22) of MiFID II as:

‘… a multilateral system, operated by an investment firm or a market operator, which brings together multiple third-party buying and selling interests in financial instruments – in the system and in accordance with nondiscretionary rules – in a way that results in a contract in accordance with Title II of this Directive’. The definition for a regulated market is nearly identical in Article 4(1)(21) of MiFID II: ‘“regulated market” means a multilateral system operated and/or managed by a market operator, which brings together or facilitates the bringing together of multiple third-party buying and selling interests in financial instruments – in the system and in accordance with its non-discretionary rules – in a way that results in a contract, in respect of the financial instruments admitted to trading under its rules and/or systems, and which is authorised and functions regularly and in accordance with Title III of this Directive.’ 6.13 Recital 7 of MiFIR is clear on the similarities between regulated markets and MTFs; it explains the intent behind that alignment and sets out how they are collectively distinct from bilateral systems where dealers advance liquidity: ‘The definitions of regulated market and multilateral trading facility (MTF) should be clarified and remain closely aligned with each other to reflect the fact that they represent effectively the same organised trading functionality. The definitions should exclude bilateral systems where an investment firm enters into every trade on own account, even as a riskless counterparty interposed between the buyer and seller [By this sentence MiFID II excludes from the definition of an MTF any functionality that is akin to a BCN]. Regulated markets and MTFs should not be allowed to execute client orders against proprietary capital [This is intended to distinguish them from systematic internalisers, who are defined as trading against proprietary capital]. The term “system” encompasses all those markets that are composed of a set of rules and a trading platform as well as those that only function on the basis of a set of rules. Regulated markets and MTFs are not obliged to operate 87

6.14  Multilateral and bilateral trading systems a “technical” system for matching orders and should be able to operate other trading protocols including systems whereby users are able to trade against quotes they request from multiple providers. A  market which is only composed of a set of rules that governs aspects related to membership, admission of instruments to trading, trading between members, reporting and, where applicable, transparency obligations is a regulated market or an MTF within the meaning of this Regulation and the transactions concluded under those rules are considered to be concluded under the systems of a regulated market or an MTF. The term ‘buying and selling interests’ is to be understood in a broad sense and includes orders, quotes and indications of interest.’

DISCRETION 6.14 Having explored one of the main distinguishing features of trading systems, the multilateral versus bilateral nature, it is important to examine the other major fault line that lies between them: the presence or absence of discretion. 6.15 The use of discretion is always present in bilateral trading, as dealers maintain the ability to decide whether to provide liquidity to a client, as well as at what price, size and time. However, that same discretion also exists in certain multilateral systems, setting apart those which are non-discretionary (RMs and MTFs) and those that are discretionary, the OTFs. The existence of discretion means that the operator of the OTF determines on the basis of a number of factors, including the preferences of each client that has submitted an order on the OTF, whether or not a transaction is concluded. It may also determine the price range at which two trading interests may cross. The operator of an OTF may for instance make adjustments to an order (always consistent with the client’s wishes) to ensure that it receives a fill from another client. By contrast, RMs and MTFs have very clearly explained functionality, set out in their rule books, pursuant to which the trading interests cross. If, in line with those rules, the buying and selling interests cannot cross successfully, the operator of an RM or MTF simply notifies the participant that their order or RFQ is not filled and only the participant may determine at that point what to do with that order or RFQ. The participant may decide to cancel it, to let it rest on the platform in case some contra-interest does materialise later, to amend it in the hope of attracting a positive contra-interest, or to resubmit it later. 6.16 The stipulation of how non-discretionary systems are to understand their obligations comes from Recital 7 of MiFIR: ‘One of the important requirements concerns the obligation that the interests be brought together in the system by means of non-discretionary rules set by the system operator. That requirement means that they are brought together under the system’s rules or by means of the system’s protocols or internal operating procedures, including procedures embodied in computer software. The term “non-discretionary rules” means rules that leave the regulated market or the market operator or investment firm operating an MTF with no discretion as to how interests may interact. The definitions require that interests be brought together in such a way as to result in a contract which occurs where execution takes place under the system’s rules or by means of the system’s protocols or internal operating procedures.’

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The demise of BCNs 6.18 6.17 Although the different types of trading functionality examined here are generally available for all asset classes, the introduction of the organised trading facility (OTF) category to accommodate multilateral discretionary trading gave rise to a debate as to whether OTFs should be allowed for shares and equity-like instruments. OTFs would have accommodated well the pre-existing BCNs in shares. However, the decision was taken at the time of the introduction of MiFID II not to allow OTFs for shares or equity-like instruments, as the European Commission believed that there were already several options for shares trading (RMs, MTFs, SIs) and they were worried about market fragmentation. In addition, the regulated markets in Europe, enjoying still significant clout with regulators and governments as national exchanges, convinced the legislators that introducing this category for shares would create further ‘unfair’ competition for the regulated markets. OTFs have therefore been mostly used for instruments which relied on the presence of brokers facilitating the inter-dealer market, the so-called interdealer brokers (IDBs). Such instruments would typically be certain categories of bonds or emissions allowances, as they are rarely traded on an RM or MTF and often rely on the presence of an interdealer market. This is recognised in Recital 8 of MIFIR: ‘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.’

THE DEMISE OF BCNS 6.18 During the years in the run-up to MiFID II, the campaign of regulated markets against competition that could further erode their market share was targeting not just new proposed categories of trading functionality like OTFs, but was also trying to limit or prohibit existing forms of trading functionality, such as the BCNs in shares, which under MiFID I were viewed as just a type of OTC trading. The weakened standing of broker dealers after the financial crisis of 2008 meant that the legislators prioritised the promotion of traditional venues, such as the historic national exchanges, over innovation offered by the BCNs. The decision was therefore made to force all types of trading into a new trading functionality categorisation and to not allow BCNs as a form of OTC trading. Under Recital 6 of MiFIR, the legislators stated that: ‘It is important to ensure that trading in financial instruments is carried out as far as possible on organised venues and that all such venues are appropriately regulated. Under Directive 2004/39/EC [MiFID  I], some trading systems developed which were not adequately captured by the regulatory regime [This refers to the BCNs]. Any trading system in financial instruments, such as entities currently known as broker crossing networks, should in the future be properly regulated and be authorised under one of the types of multilateral trading venues or as a systematic internaliser under the conditions set out in this Regulation and in Directive 2014/65/EU.’ 89

6.19  Multilateral and bilateral trading systems And as OTFs were not available for shares, that meant that the BCNs had to be accommodated as MTFs, the only remaining multilateral facility. In fact under Article 23(2) of MiFIR, the requirement became explicit that only MTFs were available: ‘An investment firm that operates an internal matching system which executes client orders in shares, depositary receipts, ETFs, certificates and other similar financial instruments on a multilateral basis must ensure it is authorised as an MTF under Directive 2014/65/EU and comply with all relevant provisions pertaining to such authorisations.’ 6.19 But, as will be discussed later, the rules applicable to MTFs do not allow their operator to also advance capital, which meant that the brokers operating an MTF could never act as a dealer or submit an order on their own MTF as riskless principal. By closing the door to OTFs and MTFs as possible categories within which a BCN could be accommodated, MiFID II essentially banned discretionary crossing networks in shares operated by brokers, an act that became recognised as a ‘ban of BCNs’. By the time of implementation of MiFID II, the trading functionality landscape looked as follows (figure 6.1), with the major fault lines set out below:

Figure 6.1

PRE-TRADE TRANSPARENCY OBLIGATIONS OF DIFFERENT TRADING SYSTEMS 6.20 Another important element that differentiates the various trading systems is the presence or absence of pre-trade transparency, as well as the form that this takes when it is there. The MiFID pre-trade transparency regime requires regulated markets and MTFs to publish in real time current bid and offer prices relating to shares along with the depth of the trading interests in those prices. Similarly, SIs are required to publish firm quotes in those shares that are 90

Pre-trade transparency obligations of different trading systems 6.22 traded on a trading venue (ToTV). Similar pre-trade transparency requirements exist for RMs and MTFs regarding non-equity instruments. However, market participants may not be happy with having their order or quotes displayed pretrade, largely because this may expose them to market arbitrage. 6.21 A dark order is one which achieves opaqueness prior to execution, in other words it is not required to be displayed in accordance with these pre-trade arrangements. In order to avoid having one’s trading intention displayed on a pre-trade basis, one has to trade away from a venue that is subject to the pretrade transparency requirement, as described in para 3.35. 6.22 Prior to MiFID II, to avoid this level of transparency, the order had to be executed OTC with the broker, whether bilaterally or through an MTF that benefited from a pre-trade transparency waiver: OTC with broker – a principal execution between a client and the broker, which is conducted ad hoc. NB: when this is done systematically, it results in a systematic internaliser, which does require some pre-trade transparency (on which more information below); or – as a cross arranged by the broker between the two clients, with the broker interposing itself for settlement purposes. When this is done systematically, it results in a BCN, which is now prohibited under MiFID II. On an organised platform subject to a waiver – under the reference price waiver (RPW) – under the negotiated trade waiver (NT) – under the large in scale waiver (LIS)

Figure 6.2  Dark pools pre-MiFID II

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6.23  Multilateral and bilateral trading systems 6.23 After MiFID II, the BCN option of these arrangements disappeared and the ability to avoid pre-trade transparency became limited to the RPW, NT and LIS, as well as the category of SIs, which, although pre-trade transparent, have significant opt-outs as to the level of transparency they offer.

RPW, NT and the double volume cap (DVC) 6.24 MiFID allows competent authorities to grant four types of waivers. Possible waivers apply to: • Reference price systems: systems where the price is determined by reference to a price generated by another system and the reference price is widely published and regarded generally by market participants as a reliable reference price (RPW). • Negotiated trade systems: systems that formalise negotiated transactions, provided the transaction: – takes place at or within the current volume-weighted spread reflected on the order book or the quotes of market makers in that share or, where the share is not traded continuously, within a percentage of a suitable reference price set in advance by the operator of the RM or MTF; or – is subject to conditions other than the current market price of the share (eg a volume weighted average price transaction). • Large-in-scale transactions: An order shall be considered to be large in scale compared with normal market size if it is equal to or larger than the minimum size of order specified in line with the liquidity profile of the relevant stock. 6.25 There is also the order management system waiver or OMS, which is not particularly relevant for these purposes and not widely used. 6.26 These waivers allow a trading platform to have a particular order book (or even the whole platform, if it has only one order book) that benefits from pre-trade transparency. However, if all trading venues adopted a waiver, then there would be no effective pre-trade transparency in the financial markets and market participants would find it hard to discern what is the prevailing market price (what is called ‘price discovery’). In the discussions that took place during the MiFID II legislative process, there were several players in the industry, especially exchanges, who were concerned about the growth of dark liquidity in the years after the implementation of MiFID I. Without doubt, the availability of dark liquidity had grown, largely due to the growth of sophistication in electronic trading, which meant that portfolio managers sought more and more to shield themselves from the impact of their orders being visible to high frequency trading firms. The growth in dark liquidity was addressing a genuine need. In addition, it was not very clear that price discovery had in fact been inhibited in the process. However, even the use of the term ‘dark’ with its sinister connotations, as well as the concerns expressed by the more established institutions like the exchanges in this debate, led politicians to take certain precautionary measures. 6.27 In an effort to minimise dark liquidity, MiFID II introduced the double volume cap (DVC) which created a major new obstacle for MTFs benefiting from the RPW and NT waivers. Essentially they were never allowed to get too big, as any extension of their liquidity beyond a certain size would result in suspension 92

Pre-trade transparency obligations of different trading systems 6.32 of the relevant shares on their venues. Under the DVC, if the proportion of trading taking place under two of the waivers from pre-trade transparency (RPW or NT) for an individual equity instrument exceeds certain thresholds, then the use of those waivers is suspended for a period of six months. The suspension for that equity instrument may either apply across the market as a whole (if trading under the waivers across all trading venues exceeds 8% of total trading across the EU in that equity instrument) or on a specific trading venue (if trading under the waivers on that venue exceeds 4% of total trading across the EU in that equity instrument). DVC suspensions take place on a monthly basis.

Transparency in the SI regime 6.28 In equities, the transparency regime for SIs is intended to inform the prevailing bid and offer that the SI can offer in retail sizes, whilst not limiting the SI in its ability to offer in truth an even better price when executing. SIs in equities and equity-like instruments are required to make public firm quotes for transactions up to a standard market size in respect of traded equities and equitylike instruments, provided that there is a liquid market in the relevant instrument. Where there is not a liquid market, SIs are only required to disclose quotes to their clients upon request. The transparency requirements for SIs only apply to when they deal in sizes up to a standard market size (SMS) and not when they deal in larger sizes. 6.29 SIs will be allowed to decide the clients to whom they give access to their quotes on the basis of their commercial policy, provided they do so in an objective non-discriminatory way. In order to limit their risk exposure, SIs are entitled to impose limits on the number of transactions with a single client which they undertake to enter at the published conditions. They may also limit the total number of simultaneous transactions from different clients where the number and/or volume of orders sought considerably exceeds the norm. 6.30 SIs decide the size or sizes at which they are willing to quote. The minimum quote size for equities and equity-like instruments is at least 10% of the standard market size of the relevant instrument. Quotes must include a firm bid and offer price or prices for a size which could be up to a standard market size for the class to which the instrument belongs. These prices must be regularly updated to reflect prevailing market conditions for the instrument in question. 6.31 Quotes must be made public on a regular and continuous basis during normal trading hours in a manner easily accessible to other market participants and on a reasonable commercial basis. Subject to complying with their best execution obligation, SIs must execute the orders they receive from clients for equities and equity-like instruments at the quoted prices at the time of receiving the order. However, they may execute at a better price in justified cases, provided that the price falls within a public range close to market conditions. This is tantamount to rendering the transparency regime rather ineffective as what the market sees (prices available for small retail size orders) has no semblance to the prices provided in fact at execution level to professional clients. SIs in equities and equity-like instruments are therefore still a good venue for clients who would prefer to protect themselves from pre-trade transparency. 6.32 The same protection from pre-trade transparency is also true for SIs in non-equities. In terms of instruments other than equities, the legal framework stipulating the requirements for systematic internalisers to make public firm 93

6.33  Multilateral and bilateral trading systems quotes in respect of bonds, structured finance products, emission allowances and derivatives can be assessed as a rather complex, the respective provisions being dispersed across MiFIR, secondary legislation as well as regulatory clarifications. 6.33 The prices quoted by systematic internalisers are required to be such as to ensure that the systematic internaliser complies with its obligations under Article 27 of the MiFID II (obligation to execute orders on terms most favourable to the client), where applicable, and must reflect prevailing market conditions in relation to prices at which transactions are concluded for the same or similar instruments on a trading venue. 6.34 To understand the systematic internaliser’s obligations with respect to pre-trade transparency for bonds, structured finance products, emission allowances and derivatives, and how these differ from the requirements for SIs in equities, it is useful to highlight some key important distinctions: 6.35 When an SI in non-equity instruments provides a quote to a client, upon the request of that client, then the firm that is an SI has the obligation to ensure that the quote: • is ‘made public’; and • is ‘available to their other clients’ (within the same or other categories of clients). 6.36 Making quotes ‘available to their other clients’ means that the quotes are disclosed and may be acted upon by other SIs’ clients (Questions and Answers on MiFID II and MiFIR transparency topics, ESMA70-872942901-35, Answer 9 updated on 3 October 2017). The respective provision is Article 18(5) of MiFIR. It is the voluntary decision of the SIs whether they make the quote available to other categories of clients. 6.37 When it comes to the pre-trade transparency obligations imposed by MiFIR on systematic internalisers in respect of bonds, structured finance products, emission allowances and derivatives, the key issue is the thresholds, which are set by the secondary legislation in respect of each instrument. The systematic internalisers’ obligation to publish a firm quote does not apply to financial instruments that fall below the liquidity threshold (Arts 18(6) and 9(4) of MiFIR). Requirements to make public firm quotes in non-equities do not apply to systematic internalisers when they deal in sizes above the size specific to the financial instrument (SSTI – Arts 18(10) and 9(5)(d) of MiFIR). 6.38 MiFID II acknowledges that in non-equities there is a wide range of instruments that could hardly be viewed as liquid and therefore have to be treated with a lighter touch. According to MiFIR (Art 18(2)), in relation to products traded on a trading venue for which there is not a liquid market, systematic internalisers must disclose quotes to their clients on request only if they agree to provide a quote. However this obligation is suspended for orders that are particularly large, or particular transactions that would expose the systematic internaliser to undue risk. ESMA clarified its views on the obligations for systematic internalisers dealing in non-equity instruments for which there is no liquid market in its Answer 5d (updated on 31  May 2017, Questions and Answers on MiFID II and MiFIR transparency topics, ESMA70-87294290135). 6.39 Furthermore, a number of provisions safeguard the ability of the systematic internaliser to properly manage risk. For example, a systematic 94

Constraints introduced to systematic internalisers 6.45 internaliser may update its quotes at any time (Art 18(3) of MiFIR) and can limit the number of transactions they undertake to enter into with clients pursuant any given quote (Art 18(7) of MiFIR).

CONSTRAINTS ON MTF AND OTF OPERATORS 6.40 Even though the relevant infrastructure was put in place by the legislators to facilitate alternative forms of trading, away from exchanges, and to encourage competition through new organised platforms, there was some concern that the new systems would continue to provide flexibility to brokers in a way that was unfair in competition terms to the exchanges. Therefore certain constraints were introduced to limit the flexibility of OTFs and MTFs and to put them on a more equal footing to the traditional exchanges. 6.41 In the case of OTFs, there was an acknowledgement that interdealer brokers had to interpose themselves between the clients in some cases. Therefore, under Recital (9) of MiFIR, an OTF operator is permitted to use matched principal trading, 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. 6.42 However, 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. This means that it is not possible for both systematic principal liquidity being offered by a firm and its affiliates and at the same time a crossing network benefiting from that liquidity. 6.43 In the case of MTFs, the operator of an MTF is not allowed to trade as a principal in the platform or to enter into matched principal transactions (Article 19(5) of MiFID II). This means that when a broker operates an MTF, it is effectively prohibited from being a member on its own platform (through its brokerage arm) as it would violate the prohibition. The effective internal segregation (through information barriers) of the MTF operation and the brokerage arm of the same firm was not deemed sufficient. The result of this prohibition was a need to hive off any MTFs that pre-MiFID II were hosted by brokers into separate legal entities.

CONSTRAINTS INTRODUCED TO SYSTEMATIC INTERNALISERS Interconnected SIs 6.44 In 2017, the European Securities and Market Authority (ESMA) urged the European Commission to adopt delegated acts to close a loophole in the systematic internaliser (SI) regime under MiFID II. 6.45 The Chair of ESMA, Steven Major, explained in a letter to the Commission that ESMA was concerned market participants could use the SI regime to ‘circumvent’ MiFID II obligations. The main concern was in respect of networks of SIs being set up to create a type of multilateral trading without being regulated as an MTF. ESMA alleged that certain investment firms, which 95

6.46  Multilateral and bilateral trading systems under MiFID I used to operate broker-crossing networks, might be seeking to circumvent the MiFID II requirements by setting up networks of interconnected SIs and other liquidity providers. It also underlined ESMA’s commitment to closely monitor this issue and to clarify the scope of SIs permitted activities and the characteristics of multilateral systems via a Q&A. 6.46 In response, the Commission felt compelled to take action and to issue a Commission Regulation amending the Delegated Regulation (EU) 2017/565 (https://ec.europa.eu/transparency/regdoc/rep/3/2017/EN/C-2017-5812-F1-ENMAIN-PART-1.PDF). This piece of legislation created a prohibition of backto-back transactions between interconnected SIs. It provided a carve-out for firms which needed to back out transactions to their affiliates so that they can centralise risk management in specific assets for prudential purposes.

Tick sizes 6.47 By way of background, the ability of the SIs in equities to provide improved prices upon execution (see para  6.31 above) meant that they had maximum flexibility to ‘cross the spread’, meaning that they could price at any point between the prevailing best bid and offer. This maximum flexibility contrasted with the limitations introduced by the regime of tick sizes that had been applicable to trading venues, whereby prices can move only by small, fixed increments. Trading venues complained that they were at a disadvantage versus SIs. Again, the legislators sought to intervene to protect trading venues from perceived competitive pressures. 6.48 As a response, the IFR introduced a new Article 17a to MiFIR, whereby quotes, price improvements on those quotes and execution prices published by SIs must comply with the tick size regime as set out by Article 48 of MiFID II. This obligation was due to become applicable on 26 March 2020. The timing of its introduction was of course unfortunate as it ended up coinciding with the onset of the Covid-19 pandemic in Europe. Consequently, ESMA issued a public statement to ensure coordinated supervisory actions by national competent authorities (NCAs) on the application of the new tick-size regime for systematic internalisers under MiFIR and the IFR. ESMA argued that this approach was needed in response to developments related to the Covid-19 pandemic and the related actions taken by the EU Member States. ESMA issued guidance of forbearance, urging competent authorities not to prioritise their supervisory actions in relation to the new tick-size regime from 26 March 2020, the application date, until 26 June 2020, and to generally apply their risk-based supervisory powers in their day-to-day enforcement of applicable legislation in this area in a proportionate manner. See also Chapter 10, in relation to the current thinking on tick sizes, especially in the UK.

ESMA’S REVIEW OF THE TRADING FUNCTIONALITY CATEGORIES 6.49 As with many other topics in MiFID II, so has the trading functionality also come under review in anticipation of further amendments in MiFID. As expected, ESMA consulted on the function of Organised Trading Facilities in particular, but also in respect of their interrelation with other trading 96

ESMA’s review of the trading functionality categories 6.50 functionalities. The results appear in ESMA’s MiFID II  Review Report (ESMA70-156-4225) of March 2021 and give an indication regarding the direction of travel. Amongst the observations ESMA has made is that the OTF regime has been used for functionalities on which mainly bonds and derivatives are traded. Wholesale market participants choose to trade on OTFs mainly for the market knowledge and network and the use is mostly associated with large transactions. Their usefulness to the interdealer markets is clearly one of effective risk management and reduction of execution costs. 6.50 Amongst the topics tackled by ESMA in its report, the following stand out: •

A consideration whether the distinction between bilateral and multilateral trading is blurred due to the setting up of networks of SIs. ESMA noted that no examples of such networks had been pointed out, so it dismissed the issue.

•

Certain SIs allegedly entered into matched principal transactions, despite the prohibition against this, by entering into back-to-back transactions with third-party entities. This allegation too was dismissed as lacking evidence.

•

Technology providers, often referred to as software or middleware providers, may operate multilateral systems without adequate authorisation. Those technology providers typically facilitate communication with and access to various sources of trading interests. ESMA chose not to carve such technology providers out of the authorisation requirements but chose instead to leave it to the discretion of the NCAs depending on the facts of each case.

•

Bulletin boards: ESMA has considered whether bulletin boards could be classified as OTFs but concluded that there were sufficient differentiating characteristics to distinguish them from OTFs. ESMA has instead decided to introduce a definition of bulletin board, concentrating on its differentiating features: –

an interface that only aggregates and broadcasts buying and selling interests;

–

the system does not allow the interaction between buying and selling interests or any communication; and

–

there is no possibility of execution or the bringing together of these interests.

•

Operation of internal crossing systems by fund managers: ESMA also attempted to deal with the longstanding question whether the transfer of instruments between funds managed by the same portfolio manager should be characterised as a multilateral trading system. It concluded that the issue is too complicated to be dealt with within the report and would be considering this issue after further analysis.

•

Matched principal trading: ESMA has recommended that the wording under Articles 47(2) and 19(5) of MiFID II be aligned to clarify that the restriction on executing orders against proprietary capital, or to engage in matched principal trading, should be interpreted as applying only to the MTF operated by an investment firm and not to the other functionalities performed by that investment firm. To the extent that it does have other functionalities it will be allowed to enter into principal capacity trades. 97

7 Mandatory trading obligations

This chapter will provide an overview of the following topics: • the history of the introduction of trading obligations in the aftermath of the financial crisis; • the expansion of the trading obligations from derivatives to shares through the medium of MiFID II; • the impact of the trading obligations on the ability of European participants to access third-country venues; and • the use of shares and derivatives trading obligations in political disputes between the EU and Switzerland and in the context of the Brexit fallout.

7.1 Mandatory trading obligations are relatively new concepts which emerged in the years following the 2008 financial crisis, as a means of promoting execution of trades on organised regulated trading venues rather than on the bilateral over the counter (OTC) market. They emerged from the belief that regulated trading venues, with well understood rule books and equal treatment of all participants, are better for the stability of the financial system. The rules implementing the mandatory trading obligations came into existence in different guises on both sides of the Atlantic in the second decade of the 21st century but soon started serving other motives too: they became significant tools in international trade negotiations and heavily politicised. Not only were they used by national exchanges to assert their dominance over other forms of trading, but they were also used to prohibit access to trading in the markets of other jurisdictions when international relations deteriorated. This was no more evident than in the use of the mandatory trading obligation as a weapon in the trade negotiations between the EU and Switzerland in 2018 and subsequently between the EU and the UK in the toxic environment of the Brexit negotiations.

THE ORIGIN OF TRADING OBLIGATIONS 7.2 During the financial crisis of 2008, large banks, hedge funds and other financial industry players had exposures to each other, arising from a complex network of bilateral trades, worth in their totality several trillion US dollars. This created a huge web of relations and hindered the efforts of regulators to determine the health condition of each institution. Being unable to assess each institution’s standing hindered in turn the regulators’ ability to take action in terms of the risks an institution posed to the rest of the financial infrastructure. In addition, this web of bilateral contracts spread contagion through the system 99

7.3  Mandatory trading obligations in ways that were poorly understood by the authorities. It was therefore decided that the more liquid contracts should be centrally cleared, interposing a clearing house between the two parties, thereby reducing the contagion and maintaining sufficient records of the financial activity for regulators to perform their function. It would be the clearing houses now that would be managing that risk in the same way they had been doing for securities traded on venues for many decades. In addition, in respect of these cleared contracts, the most liquid end of the spectrum should also be traded on trading venues rather than bilaterally (OTC). This commitment to bringing a part of the derivatives market to clearing houses and to a lesser extent on trading venues was agreed by the G20 in Pittsburgh in 2009. In their communiqué of 24–25 September 2009, the G20 leaders agreed: ‘All standardized OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest. OTC derivative contracts should be reported to trade repositories. Non-centrally cleared contracts should be subject to higher capital requirements. We ask the FSB and its relevant members to assess regularly implementation and whether it is sufficient to improve transparency in the derivatives markets, mitigate systemic risk, and protect against market abuse.’ 7.3 In Europe, the assumption of the G20 commitment coincided with the review of MiFID, which had been legislated between 2004 and 2006 and had come into force on 1 November 2007. As with all key pieces of European legislation, the authorities had to consider the effectiveness of MiFID after it had been into effect for three years. The review of MiFID started in 2010 and was concluded with the coming into force of MiFID II. Although it was evident that MiFID II had to introduce the G20 obligation to trade certain standardised derivatives on trading venues, there was no obvious reason why such an obligation would be expanded to other asset classes. However, around the same time, the Federation of European Securities Exchanges (FESE) also successfully advocated that financial markets in European shares were dominated by a preponderance of OTC transactions, and they put themselves forward as the pillars of good governance for the markets: ‘Based on the CESR (now ESMA) Technical Advice there is a composite picture of the whole EU secondary markets trading in equity after three years of implementation of MiFID […]: •

A  significant amount of trading is taking place in the OTC space, i.e. 38%.

•

The trading in the OTC space seems in particular to be quite important in relative terms when compared with the Multilateral Trading Facility (MTF – 15%) and Systematic Internaliser (SI – 2%) categories, which are the two main venue types created by MiFID to create competition with RMs and to capture the off‐exchange trading.

• The great majority of dark trading (defined as trading that happens without pre‐trade transparency) is happening in the OTC space, not in the RM or MTF platforms set up under the MiFID waivers[…]’. (FESE, Response to IOSCO Consultation 2013, available at: https://fese.eu/ app/uploads/2018/11/FESE-Response_IOSCO-CR03_Regulatory-IssuesRaised-by-Changes-in-Market-Structure_Final.pdf [accessed 4  August 2021].) 100

Shares trading obligation (STO) 7.7 7.4 The exchanges managed to argue successfully against market fragmentation in shares as a risk to the stability of financial markets. The European co-legislators became convinced that OTC trading was unregulated and needed to be reined in. They decided to limit OTC trading not only in respect of derivatives but also in respect of shares, and determined that only a small number of trades in shares should take place OTC. The vast majority should be on trading venues (regulated markets or MTFs) or on systematic internalisers, which were regulated forms of OTC trading. Therefore, they opted to introduce two trading obligations, the derivatives trading obligation (DTO) in line with the G20 commitment and the shares trading obligation (STO). 7.5 The clearing obligation that was also set out in the G20 commitment came into effect in the EU in 2012 through the implementation of EMIR (Regulation 648/2012 on OTC derivatives, central counterparties and trade repositories).

SHARES TRADING OBLIGATION (STO) 7.6

The STO is set out in Recital 11 and Article 23 of MiFIR:

‘an investment firm shall ensure the trades it undertakes in shares admitted to trading on a regulated market or traded on a trading venue shall take place on a regulated market, MTF or systematic internaliser, or a third-country trading venue assessed as equivalent in accordance with Article 25(4)(a) of Directive 2014/65/EU, as appropriate, unless their characteristics include that they: (a) are non-systematic, ad-hoc, irregular and infrequent; or (b) are carried out between eligible and/or professional counterparties and do not contribute to the price discovery process.’ 7.7 The interpretation of the word ‘undertakes’, highlighted above, has been a point of debate, as there could be a variety of meanings attached to it. If its meaning had been limited to ‘executes’ alone, the requirement to comply with the STO would have been more manageable, as it would only attach to the firms bringing the trades on venue, not necessarily its clients; therefore, a chain of brokers could have been used in order to ensure that international venues could be accessed for EU clients. However, ESMA clarified the definition of ‘undertakes’ in its communication of 13 November 2017, in which it updated the Q&A on secondary markets: ‘What is the scope of the trading obligation where there is a chain of transmission of orders? Where there is a chain of transmission of orders concerning those shares all EU investment firms that are part of the chain (either initiating the orders or acting as brokers) should ensure that the ultimate execution of the orders complies with the requirements under Article 23(1) of MiFIR. As an example, where an EU investment firm transmits an order for a share admitted to trading on a regulated market or traded on a trading venue to an EU investment firm that subsequently passes it on to a non-EEA firm, the EU investment firms should ensure the trade is undertaken in accordance with the requirements set out in Article 23 of MiFIR, ie on a regulated market, MTF, systematic internaliser or equivalent third country venue.’ In other words, to the extent that there is an EU investment firm in the chain of order transmission, the order will be trapped within the geographical boundaries of the EU by virtue of the STO. 101

7.8  Mandatory trading obligations 7.8 The expansive nature of the STO is further amplified by the types of instruments that it applies to. Its scope coves shares traded on a trading venue in the EU, a concept which itself presents its own issues. Certain shares are international non-EU shares which have been admitted to trading on European MTFs by the operators of the MTFs and not at the initiative of the issuer. For example, Microsoft shares are traded on German MTFs, not because Microsoft has chosen to have its shares traded on these trading venues, but because these MTFs have decided to trade Microsoft shares on their platforms, based on their own commercial imperative. The problem that arises from the expansive perimeter of the STO is that, should these shares have the majority of their liquidity outside the EU (as would be the case with regard to Microsoft shares), an EU investment firm will have to access the liquidity on the small EU venue only and will miss out on the majority of the liquidity overseas. This leads to the conclusion that the STO could only work without detriment to EU investors if EU venues have the majority of the liquidity or none at all. None at all would mean that the STO does not apply in the first place, as no shares are traded on an EU trading venue. Of course, the issue becomes rather more pronounced in relation to dual listed shares, where the issuer has initiated on their own accord the listing of securities on more than one venue, one in the EU and the other outside the EU. That would normally give rise to significant liquidity on both venues, with EU investment firms being unable to access the non-EU line. The only solution to this suboptimal outcome for EU investors is the option for the EU to recognise a third-country venue as equivalent under a specific equivalence determination regime. 7.9 To arrive at the conclusion of whether a trade is impacted, one has to consider the following questions: • Are the shares traded on a trading venue in the EU? If yes, they are in scope. • Are they also traded on the other venues outside the EU? If yes, then there is a question whether these venues could also be accessed. • Are these venues deemed equivalent by a decision of the Commission? If yes, the liquidity that can be accessed is not just the EU liquidity but also the liquidity on those non-EU  venues. Otherwise, the firm has to limit itself to EU venue liquidity only. • Is the firm executing the trade or submitting the order to execute the trade an EU investment firm? If so, then it must limit its options to execute the trades in the in-scope shares on the EU markets unless there are recognised third-country equivalent venues. If the entity on whose behalf the trade is executed is instead an EU corporation that has access to non-EU brokers none of the above considerations would apply. • Exceptional circumstances: even if all the conditions above are satisfied, it is possible that the EU investment firm would be able to execute the transactions OTC (still not on an unrecognised overseas venue) if the trade is of a technical nature within a limited list of types of transaction approved by ESMA. Under Recital 11 of MiFIR: ‘[the shares] trading obligation requires investment firms to undertake all trades including trades dealt on own account and trades dealt when executing client orders on a regulated market, an MTF, a systematic internaliser or an equivalent third-country trading venue. However an exclusion from that trading obligation should be provided if there is a legitimate reason. Those legitimate reasons are where trades are non-systematic, ad-hoc, irregular and infrequent, or are

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Shares trading obligation (STO) 7.11 technical trades such as give-up trades which do not contribute to the price discovery process.’

7.10

These questions are set out diagrammatically at figure 7.1:

Figure 7.1  Share trading obligations (STO)

7.11 The outcome of this logical waterfall is that an investment firm that seeks to comply with this obligation may not be able to comply with its best execution obligation, where best execution could be achieved on an overseas venue that has not been recognised as equivalent. The regulatory reasoning behind this approach supposes that the interests of the investors will not be best served if the investor’s trade is executed on a venue without the same protections as an EU  venue. Those protections are mostly linked to pre- and post-trade transparency and market structure considerations. However, Recital 11 of MiFIR is clear in subordinating best execution to the shares trading obligation: ‘It should be clarified that the best execution provisions set out in Directive 2014/65/EU should be applied in such a manner as not to impede the trading obligations under this Regulation’. Firms therefore will only consider sources of liquidity for their best execution obligation that fulfil the requirements of the STO, even if they are of lower quality to the sources of liquidity that exist globally. In addition, by virtue of the absence of any possibility to recognise third-country SIs, all overseas principal 103

7.12  Mandatory trading obligations liquidity in shares is always excluded for shares that are traded on a trading venue (TOTV) in the EU for EU participants.

EXCEPTIONAL CIRCUMSTANCES AND THE CONUNDRUM OF THIRD-COUNTRY VENUE EQUIVALENCE 7.12 As we have seen above, the STO requirement clearly only kicks in wherever the shares are TOTV in the EU. Considering there is a very large number of non-European shares traded on European MTFs which have simply been admitted to trading at the initiative of the MTFs, the EU risks having EU participants being limited to liquidity that is less deep, varied and unable to achieve the objectives of market participants. This is further accentuated by the fact the EU can only resolve this conundrum by recognising third-country trading venues; it can never recognise a significant dealer that behaves as an SI outside the EU. But does this mean that ESMA has to consider every venue in the world on which there are shares that are traded which are also traded on an EU venue? And if it has not granted that equivalence, would that prohibit EU investors from accessing that liquidity? 7.13 ESMA responded to the challenge of having to consider a venue from an equivalence perspective with a remarkable piece of sophistry. If ESMA has considered the jurisdiction, then market participants have to comply with the conditions of any ESMA decision, but if there is no ESMA determination, it means that the market has not been considered and therefore not significant enough from an EU liquidity perspective. In the latter case, EU investors can access the third-country venue without a problem. 7.14 This approach was set out by ESMA in the press release that accompanied the update to the Q&A on secondary markets that was published in November 2017: ‘ESMA is aware that the scope of the trading obligation in Article 23, and the absence of the relevant equivalence decisions, might cause issues for investment firms that wish to undertake trades in non-EEA shares in the primary listing venues of such shares. ESMA and the European Commission are working closely together to resolve those issues. While the Commission is preparing equivalence decisions for the non-EU jurisdictions whose shares are traded systematically and frequently in the EU, the absence of an equivalence decision taken with respect to a particular third country’s trading venues indicates that the Commission has currently no evidence that the EU trading in shares admitted to trading in that third country’s regulated markets can be considered as systematic, regular and frequent.’ The reference to shares not being traded on a systematic, regular and frequent basis is tantamount to saying that the shares are not subject to the STO. Confronted with the mammoth task of having to assess all international markets, ESMA opted to assess only the ones it deemed significant and allow access to all the others. 7.15 Regarding the United States, an equivalence determination was made in respect of US venues that were explicitly referenced in an appendix to the decision, although internalisation of shares by US dealers was not something permitted for US shares in the decision, following closely the inability to recognise third-country SIs. 104

The STO as a political weapon: the Swiss experience 7.18

THE STO AS A POLITICAL WEAPON: THE SWISS EXPERIENCE 7.16 Unsurprisingly, considering the geographic proximity and time zone alignment, the Swiss and EU markets have been historically closely intertwined. A  large amount of liquidity in Swiss shares has been traded for many years on EU MTFs. At the time of the introduction of MiFID II, Switzerland was, apart from the United States, the most important market for which the European Commission had to make an equivalence determination based on the advice of ESMA. A decision not to provide that determination would have meant that the sizeable EU portfolio managers, EU pension funds and EU banks would stop accessing the SIX, the Swiss exchange, for the purposes of trading Swiss shares and would have to limit themselves to European venues, potentially threatening the viability of the Swiss market altogether. 7.17 In 2017, at the time of the introduction of MiFID II, Switzerland was going through a significant trade negotiation with the EU on all matters of trade, and certainly not focused on financial markets. The EU decided after lengthy deliberation to give the Swiss a chance to come to the table for the trade negotiation and gave them breathing space by providing a 12-month timelimited recognition (C/2017/9117: Commission Implementing Decision (EU) 2017/2441 of 21 December 2017 on the equivalence of the legal and supervisory framework applicable to stock exchanges in Switzerland). By the end of 2018, when the timeframe was about to expire, a further six-month extension was granted by the EU until the end of June 2019. According to the European Commission’s explanation of the six-month extension, the measure was intended to ensure that businesses and markets could continue to operate smoothly and without any disruptions until the cliff edge of the end of 2018. Rather tellingly, the Commission said in its announcement that ‘when proposing the extension of the equivalence for Swiss trading venues, the Commission has considered the outcome of the negotiations of the Institutional Framework Agreement, as well as the decision by the Swiss Federal Council to launch a consultation on the agreement that will last until spring 2019.’ The Institutional Framework Agreement was the foundational agreement of the bilateral relations between the EU and Switzerland and had everything to do with commercial and trade matters but was not directly relevant to trading in shares or the financial markets. 7.18 As the deadline of June 2019 approached, matters came to a head. The negotiations on the Institutional Framework Agreement were not going as well as expected and the EU decided to escalate the threat further. It decided that it was not going to extend the temporary equivalence of Swiss venues for the purposes of the EU STO any further. The market started getting ready for significant disruption, as SIX constituted a significant part of liquidity in Swiss shares and being artificially cut off from it would have been detrimental for the quality of execution. But then in an act that surprised many, the Swiss authorities outmanoeuvred the European Commission. On 27  June 2019, the Federal Department of Finance of Switzerland confirmed that it was going to activate an ordinance as of 1  July 2019, as it no longer expected that the European Commission would extend the Swiss exchange equivalence in good time. The Swiss ordinance made it a criminal offence for any venue in the EU and any participant on these venues to transact in Swiss shares. One could only imagine CEOs of European MTFs being arrested in Switzerland during their ski break for breaking the conditions of the Ordinance. All EU venues were quick 105

7.19  Mandatory trading obligations to comply and stopped trading the Swiss shares as of 1 July 2019. Ironically, the result of this development was that the EU STO did not apply at all in the first place, as the Swiss shares were no longer TOTV. And not only was the EU’s threat to withdraw equivalence ineffective but it had backfired spectacularly, with all Swiss shares activity being conducted exclusively in Switzerland. 7.19 Following Brexit, in February 2021, the Swiss stock exchange was recognised as equivalent by the UK, and as a reciprocal gesture, the Federal Department of Finance of Switzerland lifted the restrictions on the UK in return. At the same time, the Swiss Financial Market Supervisory Authority, FINMA, has added the UK trading venues to the list of recognised foreign trading venues pursuant to the Federal Council Ordinance of 30 November 2018 (Ordinance). With the completion of this process, trading in Swiss shares on UK trading venues resumed, whereas the ban on trading in the EU remained in place.

THE STO IN THE BREXIT CRISIS 7.20 The Swiss experience was a vivid premonition of what was to take place with the UK in advance of its complete exit from the EU, at the end of the transition period, 31 December 2020. As part of Brexit preparations, the UK had ‘onshored’ EU legislation, by introducing UK legislation that essentially replicated that of the EU, other than in some minor respects. In respect of MiFID, the UK had been one of the most active participants in shaping the legislation, especially in respect of the original MiFID I, but also with more recent changes regarding inducements and other obligations. Having been subject to MiFID during its membership, like all other Member States, the UK implemented legislation introducing it in UK law, for the post-Brexit era, verbatim. Where the European Commission had a role in MiFID II, that was assumed by Her Majesty’s Treasury, and where ESMA had a role under the original legislation, that role was assumed by the FCA in the UK. The UK onshored version of MiFID was otherwise the same, including the STO. That meant that upon the UK’s departure, there would be a number of overlapping STO requirements in the UK and the EU that would be irreconcilable. In the first instance, the UK would have EU shares that were traded on UK MTFs (and UK MTFs represented significant liquidity in EU shares) and on the other hand under the EU STO, UK shares would be in scope as they were traded on EU MTFs. The situation became even more pronounced in respect of dual-listed shares, of which there were many, as well as in respect of Irish shares and ETFs, which – despite continuing to be EU shares after Brexit – had the majority of their liquidity in the UK. 7.21 ESMA released a public statement in October 2020 (26 October 2020 – ESMA70-155-7782) that clarified the application of the EU’s STO following the end of the UK’s transition from the EU on 31 December 2020. ESMA decided to narrow down the problem of overlapping STOs by deciding that only shares admitted to trading in the EU in a currency other than GBP would be in scope for the EU STO. This currency approach supplements the EEA-ISIN approach outlined in a previous ESMA statement of May 2019. This revised guidance aims at addressing the specific situation of the small number of EU issuers whose shares are mainly traded on UK trading venues in GBP. ESMA based its decision on the idea that such trading by EU investments firms occurs on a non-systematic, ad-hoc, irregular and infrequent basis. Therefore, those trades are exempted from the STO. 106

The impact of the impasse on the STO 7.24 7.22 In the absence of an equivalence decision in respect of the UK, the previewed adverse effects of the application of the STO on EU portfolio managers following the end of the transition period have been the same as in the no-deal Brexit scenario considered in the previous ESMA statement.

THE IMPACT OF THE IMPASSE ON THE STO 7.23 As the two parties in the Brexit negotiation have never reached a fullyfledged agreement on financial services, EU investment firms were forced by ESMA to access EU shares in EU currencies on EU venues. This automatically created an assumption that significant liquidity in these shares would always be bound to EU venues. This anchored liquidity was destined likely to also attract other international players who would seek to meet EU market participants. EU venues therefore would immediately have an advantage over UK MTFs that seek to continue providing liquidity in EU shares. 7.24 This outcome was completely predictable at the time when the Brexit negotiation was underway and the anchoring of that liquidity drove UK venues to rethink their strategy. If they remained in the UK alone, they risked missing out on this anchored liquidity. They therefore decided to establish venues in the EU, predominantly in Amsterdam and Paris, ‘cloning’ their UK platforms, but focusing their EU instances on EU shares. Faced with a de facto migration of a significant amount of EU shares liquidity to the EU, the UK had several choices to make: it could dig its heels in and insist that UK investment firms traded the entire universe of EU and UK shares on UK venues, or it could mirror the approach of the EU and render only UK shares subject to the UK obligation. The former approach risked disintermediating the UK from international flows. It is often the case that non-European clients are serviced for their European liquidity needs out of UK investment firms that offer them the certainty of English law and the supervisory standards of the FCA. These UK brokers then route this flow to affiliates in the EU and source the relevant liquidity this way. Were the UK insistent on implementing the UK STO in a strict fashion, those incoming international clients would be trapped in the UK unable to access EU liquidity, which could mean that they would prefer to have a direct relationship with EU brokers. This would have been very detrimental to the City. In a statement last updated in December 2020, the FCA chose to preserve the role of the City in these flows and to disapply the STO altogether. Their view was no ISIN or currency approach could resolve the impasse and ideally the two regions would recognise each other’s venues and allow participants to access liquidity where it serves themselves and their clients best. The FCA defended the role of best execution as the guiding principle (www.fca.org.uk/news/ statements/fca-statement-share-trading-obligation [accessed 4  August 2021]). By deciding to reject the turf war for EU shares liquidity and to allow UK firms to be guided by best execution, the FCA conceded essentially the migration of the EU shares liquidity to EU  venues, which took place en masse at the beginning of January 2021. Amsterdam instead became the centre of European shares liquidity in January 2021 with over €9bn worth of shares traded that month compared with €8bn in the UK (www.thetimes.co.uk/article/londonloses-out-as-share-trading-crown-goes-dutch-glztg98w2 [accessed 4  August 2021]). 107

7.25  Mandatory trading obligations

THE DERIVATIVES TRADING OBLIGATION 7.25 The derivatives trading obligation was also implemented through MiFID II and in particular in Article  28 of MiFIR. This required financial counterparties that were defined in EMIR and certain non-financial counterparties to conclude transactions in specified derivatives on an organised venue, unless the transactions are intra-group (for instance, transactions passing trading book risk from one legal entity of the same group to another). The organised venues permitted for these purposes are regulated markets (exchanges), MTFs, OTFs or third-country venues for which there is a recognition decision. For the role of MTFs and OTFs and their respective differences please see Chapter 6. 7.26 As previously mentioned, the scope of instruments subject to this obligation cannot be too wide as derivatives are by definition not very commoditised as a product. To ensure that there is absolute clarity as to what is subject to the obligation, under Article 34 of MiFIR, a register of derivatives subject to the trading obligation is published by ESMA. The register includes the relevant types of derivatives, the venues where they are admitted to trading or traded, and the dates from which the obligation takes effect. 7.27 ESMA regularly monitors the activity in derivatives which have not been declared subject to the trading obligation in order to identify cases where a particular class of contracts may pose systemic risk and to prevent regulatory arbitrage between derivative transactions subject to the trading obligation and derivative transactions which are not subject to the trading obligation.

Trading obligation procedure 7.28

Under Article 32 of MIFIR, ESMA develops the RTS, setting out:

•

which of the class of derivatives declared subject to the clearing obligation in accordance with EMIR or a relevant subset thereof shall be traded on the venues on the basis of the DTO; and

•

the date or dates from which the trading obligation takes effect, including any phase-in and the categories of counterparties to which the obligation applies.

7.29 The Commission then adopts the relevant RTS. In order for the trading obligation to take effect: •

the class of derivatives that have been declared subject to the DTO must be admitted to trading or be traded on at least one trading venue (RM, MTF or OTF); and

•

there must be sufficient third-party buying and selling interest in the class of derivatives or a relevant subset thereof so that such a class of derivatives is considered sufficiently liquid to trade only on the venues referred to in Article 28(1).

7.30 In order to decide whether a derivative subject to the DTO is liquid, ESMA has to consider: •

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the average frequency and size of trades over a range of market conditions, having regard to the nature and lifecycle of products within the class of derivatives;

Brexit implications for derivatives trading 7.35 •

•

the number and type of active market participants, including the ratio of market participants to products/contracts traded in a given product market; and the average size of the spreads.

7.31 ESMA takes into consideration the anticipated impact that trading obligation might have on the liquidity of a class of derivatives and the commercial activities of end users which are not financial entities. ESMA may also determine whether the class of derivatives is only sufficiently liquid in transactions below a certain size.

Conditions for third-country venue equivalence 7.32 Under Article  28(4) of MiFIR, the legal and supervisory framework of a third country is considered to have equivalent effect where that framework fulfils all the following conditions: • trading venues in that third country are subject to authorisation and to effective supervision and enforcement on an ongoing basis; • trading venues have clear and transparent rules regarding admission of financial instruments to trading so that such financial instruments are capable of being traded in a fair, orderly and efficient manner, and are freely negotiable; • issuers of financial instruments are subject to periodic and ongoing information requirements ensuring a high level of investor protection; and • it ensures market transparency and integrity via rules addressing market abuse in the form of insider dealing and market manipulation. 7.33 A decision of the Commission under this paragraph may be limited to a category or categories of trading venues. In that case, a third-country trading venue is only included in para 1(d) if it falls within a category covered by the Commission’s decision. 7.34 Currently the derivatives subject to the DTO in the EU are certain tenures of interest rate swaps in liquid currencies and a small number of Index CDS. The only countries expressly recognised as equivalent are the United States and Singapore (www.esma.europa.eu/sites/default/files/library/public_ register_for_the_trading_obligation.pdf [accessed 4 August 2021]).

BREXIT IMPLICATIONS FOR DERIVATIVES TRADING 7.35 In a similar vein to the case of the STO, the issues of recognition of third-country venues became heavily politicised at the time of the Brexit negotiations and the immediate aftermath of the expiry of the transition period. The UK became a third country not just in name but also in effect at the end of 2020. Considering the ruleset and the requirements followed by the UK up to that point were identical to those of the EU and, more importantly, as the EU had already recognised two other jurisdictions with very different rulesets as equivalent, the natural expectation would have been that the EU and the UK would recognise each other’s venues as equivalent for the purposes of discharging the DTO. 109

7.36  Mandatory trading obligations 7.36 The EU took its time and eventually suspended the majority of equivalence determinations for the year beyond 2021. The UK continued to keep the door open for negotiation on the topic. The decision was evidently out of the hands of the regulators as, under Recital 17 of MiFIR, the equivalence decisions are conferred to the Commission: ‘… relating to the adoption of the equivalence decision concerning the third-country legal and supervisory framework for the provision of services by third-country firms or third-country trading venues for the purpose of eligibility as trading venues for derivatives subject to the trading obligation and of access of third-country CCPs and third-country trading venues to trading venues and CCPs established in the Union.’ If the Commission has decided to not accommodate a departing Member State, the governance of that country’s venues becomes quickly irrelevant. 7.37 The outcome of that impasse would be that counterparties at either side of the English Channel would face contradictory obligations that would be impossible to satisfy simultaneously. An interest rate swap subject to the EU and UK DTOs entered into by a German bank with a British bank would simply find it impossible to be traded on an EU venue (as it would breach the British bank’s UK DTO) or a UK venue (where it would breach the German bank’s EU DTO). 7.38 As seen above, the US and Singapore had already been recognised by the EU as equivalent prior to Brexit and those recognitions were also adopted by the UK as part of its onshoring of pre-existing EU rules and regulations. Therefore, the impasse would lead the transaction between the British and German banks to a US (or Singaporean) venue if both banks have access to it, as US  venues are recognised by both the UK and the EU. Of course, not all counterparties have access to third-country venues, as such memberships are expensive to maintain. The UK therefore arrived at a new guidance using the FCA’s temporary transitional powers (TTP). If a UK and EU counterparty subject to contradictory DTOs have access to a third-country venue, they expect the transaction to be concluded there. If they do not, then they would allow UK counterparties to transact on an EU  venue. (www.fca.org.uk/news/statements/ temporary-transitional-power-derivatives-trading-obligation [accessed 4 August 2021]). This concession, which is a more flexible approach to that of the EU maintains some pressure on the EU, whilst giving some additional flexibility to UK market participants to use EU venues on an exceptional basis. 7.39 As we will see in Chapter 10, trading obligations are one of the many legal and regulatory hurdles which the EU and the UK will both have to face in the future. Their existence, however necessary to a smaller degree, has been magnified in importance in the recent past. Trading obligations have become instruments of pressure to ensure that counterparties come to the table to discuss any number of obligations, sometimes unrelated to the financial sector. And although handling these repeated cliff-edge situations must have provided regulators everywhere with unimaginable headaches, the politicians are unlikely to give up a useful tool in their negotiation tactics.

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8 Electronic trading

In this chapter, the following points will be explored: • the fundamental concepts of algorithmic trading, high frequency trading and direct market access; • the hazards potentially faced by the market; • the key requirements applicable to the activities; and • the proposals for the evolution of the electronic trading regime. 8.1 The fundamental principle of electronic trading is that – irrespective of the means by which it is undertaken – it is still trading and therefore all legal and regulatory requirements applicable to manual (or as it is called, ‘high touch’ trading) apply to electronic trading (or ‘low touch’ trading) in equal measure. The main difference from high touch trading is that electronic trading can enjoy speed and automation that go beyond what mere human faculties can achieve. The overall experience is that of trading ‘on steroids’. More importantly, electronic trading coexists with high touch trading on the same trading platforms, thereby creating a heady mix of risks for those market participants who may not have the same means of competing with electronic trading market participants. Regulation has therefore stepped in to provide additional layers of protection to the market by imposing further obligations on those market participants that pursue trading through electronic means.

ALGORITHMIC TRADING 8.2 In the ordinary course of trading, a person responds to signals provided by the market in developing his or her exact trading strategy. For instance, selling ten thousand shares would not be as simple as placing a single sale order on the exchange for the entire number. If one did that, there could be price deterioration as the seller would be matching with a series of resting buy orders on that one exchange at ever diminishing prices resulting in a bad outcome for the seller overall. Instead the seller could look at a different strategy so that they can achieve the sale with optimal price results: they could do that by splitting the order in various smaller segments (child orders) which in turn would be placed on multiple venues to pick up the best available prices in one sweep; if the order is not fully executed and the next layer of available resting buy orders are at a worse price, the seller can wait for the buying interest to recover and come back to the market to finish the order. To achieve this, the seller has to continuously receive information on market prices from multiple venues and to manage the child orders dynamically in response to that information. To demonstrate that example, let us put some figures against the practice: 111

8.3  Electronic trading Central Limit Order Book of London Stock Exchange in Stock X Orders Sell orders ranked on a price / time priority

Buy orders

Match?

1

10:35:00am: Sell 10000 shares of Stock X at no worse than £100 per share; accept partial fills

10:25:00am: Buy 100 shares of stock X at no more than £101

Match between Sell order 1 and buy order 1 for 100 shares

2

10:35:00am: Sell 100 shares of Stock X at no worse than £100.1 per share: whole order to be filled only

10:26:00am: Buy 1000 shares of stock X at no more than 100.8; partial fills accepted

Match between Sell order 1 and buy order 2 for 1000 shares

3

10:35:30am Sell 2350 shares of Stock X at no worse than £100.1 per share, accept partial fill

10:35:00am: Buy 2550 shares f stock X at no more than 100.2; whole fills only

Match between Sell Order 1 and buy order 3 for 2550

4

10:35:15am Sell 1000 Shares of Stock X at no worse than £100.3 per share: whole order to be filled only

10:26:00am: Buy No match between 3000 shares of stock Sell order 1 and buy X at no more than order 4 £99.99

8.3 With such a strategy, the market would become aware that there is a large sell order resting on the book and would move to provide the lowest level of buy orders to meet it. This means that the partial execution that it has achieved above (the sale of 3650 shares out of 10000) will be accompanied later by a series of partial executions at a low price. But what if the order was placed in increments of child orders of 1,000 shares and in a series of venues? On the LSE it would achieve the execution of a sale of 1,000 shares at £101 (for the first 100 shares) and £100.8 for the next £900. If another 1,000 shares had been placed at CBOE, and another 1,000 shares at Turquoise with similar results in each case, the result would be an overall execution closer to the £101 mark. After some time, the same strategy could be repeated with the placement of a new series of child orders, showing another smaller increment of the larger order to the market. The process can be repeated as many times as it needs to do so to get the parent order executed. 8.4 Such a strategy could in theory be pursued by an individual, but as it is based on simple parameters of logic and relies on the dynamic change of observable market data, it is much more efficient for it to be pursued by a computer that has been programmed on the basis of these parameters to execute this strategy. When a computer takes on this role and there is no human intervention prior to the submission of each order, this is called algorithmic trading. MiFID II defines algorithmic trading as: ‘trading in financial instruments where a computer algorithm automatically determines individual parameters of orders such as whether to initiate the order, the timing, price or quantity of the order or how to manage the order after its submission, with limited or no human intervention’. 112

Algorithmic trading 8.8 To ensure that it does not capture communication lines and other connectivity software that does not perform the same ‘intelligent function’, the definition excludes: ‘any system that is only used for the purpose of routing orders to one or more trading venues or for the processing of orders involving no determination of any trading parameters or for the confirmation of orders or the post-trade processing of executed transactions’. (MiFID II, Art 4(1)(39)) 8.5 Algorithms can be further split between two categories: investment algorithms and trading algorithms. Investing algorithms are focused on determining the appropriate configuration of investments that delivers an investor’s strategy. This means that it can choose between different instruments or develop an optimal portfolio that can achieve targeted returns on the investment. On the other hand, a trading algorithm is preoccupied with the correct strategic execution of a trade, looking to optimise the execution strategy.

Requirements imposed on algorithmic trading 8.6 As part of its objective of having more efficient and resilient markets, MiFID II seeks to keep pace with technological developments. Whilst recognising the benefit of new trading technologies, MiFID II is also aimed at addressing the potential risks from increased use of technology. As explained in Recital (63) of MiFID II: ‘Those potential risks from increased use of technology are best mitigated by a combination of measures and specific risk controls directed at firms that engage in algorithmic trading or high-frequency algorithmic trading techniques, those that provide direct electronic access, and other measures directed at operators of trading venues that are accessed by such firms’. 8.7 The definition of ‘algorithmic trading’ and in particular the question of ‘no human intervention’ is further elaborated in Article  18 of Regulation 2017/5653 (MiFID Delegated Regulation): ‘[…] a system shall be considered as having no or limited human intervention where, for any order or quote generation process or any process to optimise order-execution, an automated system makes decisions at any of the stages of initiating, generating, routing or executing orders or quotes according to pre-determined parameters’. 8.8 The use of algorithms is not a risk in its own right. However, regulators would like to understand whether risky behaviour, when observed in the market, originates from an algorithm and, if so, from which algorithm or combination of algorithms. MiFID II therefore imposes notification requirements on market participants that operate algorithms. In particular: • Notification to the national competent authority (NCA) of the Home Member State and to the NCAs of the trading venues where it deploys its algorithmic trading strategies: under Article  17(2) of MiFID II, an investment firm that engages in algorithmic trading shall notify the NCA of its home Member State and of the trading venue at which the investment firm engages in algorithmic trading as a member or participant of the trading venue. 113

8.9  Electronic trading •

•

Provision of information upon request about its trading algorithms, systems and controls to its Home Member State NCA: the Home Member State NCA may share this information with the NCAs of the trading venues where the investment firm deploys its strategies. The NCA of the investment firm may require the investment firm to provide, on a regular or ad-hoc basis, a description of the nature of its algorithmic trading strategies, details of the trading parameters or limits to which the system is subject, the key compliance and risk controls that it has in place to ensure the conditions laid down in Article  17(1) of MiFID II are satisfied and details of the testing of its systems. The NCA of the investment firm is required, on the request of the competent authority of a trading venue on which the investment firm is engaged in algorithmic trading, to communicate the information referred to above without undue delay. Compliance with specific organisational requirements set out in RTS 6: see para 8.38.

8.9 However, and in contrast to HFT, the mere use of algorithmic trading techniques other than HFT does not trigger the requirement for that person to be authorised as an investment firm.

HIGH FREQUENCY TRADING 8.10 As mentioned above, dynamic access to market data and speed of response are the drivers for the migration of manual trading into algorithmic trading. This tendency can be taken to its ultimate conclusion and become a self-contained trading strategy, called high frequency trading or HFT. HFT firms try to make small profits throughout the trading day by looking across multiple markets and exploiting the small differences that they observe between different bids and offers on the same stock across exchanges. 8.11 If, for instance, there is an offer at £100.1 in stock X on Venue A and an offer at £100.3 in stock X  for the same size on Venue B, they can lift the offer of £100.1 by bidding at that price on venue A and then sell the position at £100.29 on venue B, making a profit of £0.19 minus any trading costs. As seen in the description of market structure and the role of HFT in para  6.2, the idea behind HFT firms is that they materialise profit and loss in a single day by entering and exiting positions continuously throughout the trading day, making small profit or loss with each trade. As a general rule, they do not hold over positions in stocks after the end of the trading day: they end the day  flat. 8.12 To be able to be make those miniscule advances over the rest of the market, HFT firms need to be faster than everyone else. Therefore, they seek out the fastest possible access to the market, reducing the time that it takes them to read a market signal and to respond to it, a time loop that is often called ‘latency’. Sometimes, their trading strategies are also called ‘low latency’ strategies, as they are equally about the frequency of trading as they are about the speed of their response to the market. Latency is occasioned by the physical length of the cables used to transmit the data between the physical location where the matching engine of the trading venue is located and the location of the HFT firm’s technological infrastructure. The longer the cable is the longer it takes for the message to arrive from the venue into the firm’s infrastructure and for 114

High frequency trading 8.16 the firm to respond to the message. In an environment when microseconds are valuable, it is imperative for HFT firms to be as proximate as possible to the trading venue. 8.13 Accordingly, MiFID II defines a high-frequency algorithmic trading technique’ as: ‘… an algorithmic trading technique characterised by: (a) infrastructure intended to minimise network and other types of latencies, including at least one of the following facilities for algorithmic order entry: co-location, proximity hosting or high-speed direct electronic access; (b) system-determination of order initiation, generation, routing or execution without human intervention for individual trades or orders; and (c) high message intraday rates which constitute orders, quotes or cancellations;’ (MiFID II, Art 4(1)(40)). 8.14 The definition includes the mechanisms through which low latency may be achieved: • Co-location: this means that the HFT firm’s trading engine is located in the same premises as those of the trading venue. Having that level of proximity is so valuable that trading venues are making additional revenue by leasing this space to those firms that are willing to pay for it. As long as they offer this facility on a non-discriminatory basis to any member that is willing to pay the price, the practice of offering this level of proximity is permitted by regulation. Co-locating one’s own technology in a plant owned by an exchange comes with a complex set of legal issues of its own. The security of the plant from any physical or technological interference (cybersecurity) is paramount for the HFT firm and there would normally be extensive protocols determining the alerts regarding cyberattacks, the level of liability attaching to the trading venue and the protocol for access to the plant. • Proximity hosting: this option is the next best thing to co-location, as it provides sufficient proximity without being embedded in the infrastructure of the trading venue. Normally large industrial estates proximate to the location of a trading venue engine could be offered as secure location in which the trading infrastructure of HFT firms could be located. • High-speed direct electronic access or, as otherwise called, sponsored access. There is a further discussion on direct electronic access in para 8.27 below. 8.15 The need for colocation with key players means that many European exchanges maintain their data centres in industrial estates close to London, in Basildon and Slough. 8.16 Article 19 of MiFID Delegated Regulation (2017/565) further defines a ‘high message intraday rate’ as the submission on average of any of the following: ‘(a) at least 2 messages per second with respect to any single financial instrument traded on a trading venue; 115

8.17  Electronic trading (b) at least 4 messages per second with respect to all financial instruments traded on a trading venue’; where only messages concerning financial instruments for which there is a liquid market are to be included in the calculation.

Advantages and disadvantages of HFT 8.17 Through their frequent and ongoing activity, HFT participants are providing liquidity in the market and help minimise price dislocations between venues, as seen in the example above. Their role is tantamount to electronic market making in the shares in which they are active, by being permanently available to trade against other market participants. This particular attribute of liquidity provision is often highlighted by the HFT community as one of the fundamental positive contributions of HFT firms to the market place. In addition, their constant presence is something that makes regulators hesitant to impose debilitating restrictions on HFT participants as they may be concerned about a penalisation of innovation in trading. 8.18 Exchanges also like this type of flow as it allows them to give the impression of great liquidity concentration. They therefore incentivise HFT firms to be active on their venues by providing them with fee incentives and accommodating their low latency needs. 8.19 However, there are some significant risks that have been widely recognised in legal and regulatory literature: •

Speedier access to markets in advance of other participants: the speed of trading may allow HFT firms to arbitrage the markets by using information that they can see in respect of other trading participants’ activity on the venue. By the time an order is placed on an exchange by a retail customer, an HFT firm can place a competing order in another venue and then impact the liquidity on the venue on which the retail trader had placed their order. This sequence creates the impression that the market constantly moves against the less equipped market participant, who then finds it impossible to achieve best execution. The risk for the man on the street of being arbitraged by HFT participants and the cooperation of the exchanges in this process was brilliantly described in Flash Boys: A Wall Street Revolt, by Michael Lewis (W W Norton & Co, 2014).

•

Ability to accentuate price fluctuation: although the ability of HFT to arbitrage the market may move prices closer together cross-market, their ongoing involvement with market activity may itself provide an accelerating effect on trends created by other market participants. An algorithm of one market participant, when malfunctioning, can generate strange market dynamics. These could be severely accentuated as HFT trading strategies engage with the orders placed by the malfunctioning algorithm.

•

Ability to withdraw HFT liquidity at short notice: being present in the market at all times without a firm commitment creates a false sense of reassurance. If there is market turmoil, these market makers are not committed to staying involved but may decide to withdraw for a period of time so that they do not suffer serious losses. The sudden withdrawal of

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High frequency trading 8.22 liquidity may have a negative impact on markets as investors find it hard to unwind their positions. 8.20 Most importantly, HFT activity, even with a full suit of controls, may have a tremendous impact on markets and the firms operating such algorithms, if it goes wrong through any serious malfunction. A  prime example of such malfunction took place in the US when Knight Capital suffered one of the most notorious ‘incidents’ in US history. Knight Capital was one of the largest, if not the largest, market participants in equities capital markets in the US, largely through its systematic trading strategies. In August 2012, over the course of less than an hour, its own existence came under threat, when Knight Capital caused a major stock market incident, resulting in very large trading losses for the firm. The main reason that caused the incident was human error: one of the technologists had not copied a piece of code to one of the servers of Knight Capital, within which an instance of the smart order router was hosted. This had a knock-on impact by erroneously activating another piece of code called ‘Power Peg’ and setting it into action. Power Peg ironically had been a control, which was meant to test the upper and lower end of share prices. All orders that went through the impacted server that morning had attached to them the instruction to Power Peg. There were 212 parent orders executed through that server. They resulted in four million child order executions in approximately 45 minutes, trading 397 million shares in over 150 companies in that time (https:// www.sec.gov/litigation/admin/2013/34-70694.pdf [accessed 4  August 2021]). The losses suffered by Knight capital exceeded US$400 million. For a time, there a was a question whether the firm would be viable, until it was purchased and absorbed by one of its rivals.

Requirements imposed on HFT 8.21 To mitigate the risks identified above, MiFID II has established a regulatory framework that applies to HFT entities even if they are not in principle regulated. The first step is to require such entities to be authorised and therefore regulated. Where a firm is using a high-frequency algorithmic trading technique, the exemption from authorisation as an investment firm when only dealing on own account under Article 2(1)(d) of MiFID II is no longer available. Nor are the exemptions under Article 2(1)(e) of MiFID II for operators dealing on own account in emission allowances and Article 2(1)(j) of MiFID II for commodity firms. The required authorisation aims at ensuring that those firms are subject to organisational requirements under MiFID II and that they are properly supervised. 8.22 Separately, to mitigate the risks that arise from the ability to withdraw quotes at a short notice and to live up to their market making commitment, high frequency trading firms may trigger through their activity the requirement to enter into market making agreements with the venues on which they are active. Recitals (62) and (113) of MiFID II state that there are two main goals in establishing market making agreements. First, as advanced technologies may bring new risks to the market, MiFID II aims to maintain market participants’ ability to transfer risks efficiently during stressed market conditions ensuring sufficiently liquid markets. Secondly, the Article 17 provisions aim at introducing an element of predictability to the provision of liquidity in the order book by requiring contractual obligations for firms deploying certain types of strategies. To this end, Article 17(3) of MiFID II requires investment firms that engage in 117

8.23  Electronic trading algorithmic trading to pursue a market making strategy to notify the trading venue where such strategy is deployed and to enter into a binding agreement with specific quoting obligations. These obligations include carrying out their strategy continuously during a specific proportion of the venue’s trading hours, except under exceptional circumstances, and have in place effective systems and controls to ensure the fulfilment of these quoting obligations. 8.23 To determine when an algorithmic trading firm has triggered the requirement to enter into a market making agreement, Article 17(4) details when an investment firm should be considered as pursuing a market making strategy. This is the case when the firm posts ‘firm, simultaneous two-way quotes of comparable size and at competitive prices relating to one or more financial instruments on a single trading venue or across different trading venues, with the result of providing liquidity on a regular and frequent basis to the overall market’. 8.24 Article 48 of MiFID II similarly requires regulated markets to have in place ‘written agreements with all investment firms pursuing a market making strategy on the regulated market’ as well as ‘schemes to ensure that a sufficient number of investment firms participate in such agreements which require them to post firm quotes at competitive prices with the result of providing liquidity to the market on a regular and predictable basis, where such a requirement is appropriate to the nature and scale of the trading on that regulated market.’ Article 18(5) extends these obligations to MTFs and OTFs. 8.25 Separately, Article  48(8) of MIFID II requires that the rules of the regulated markets on co-location services are transparent, fair and nondiscriminatory. Further detailed requirements regarding co-location services are provided in Commission Delegated Regulation (EU) 2017/573 (RTS  10). Article 1 of RTS 10 clarifies when the co-location services are considered fair and non- discriminatory. Article 1(2) clarifies that all users subscribed to the same services should obtain the same level of service. Article 1(3) imposes on trading venues the obligation to monitor the connections and latency measurements, while Article 1(4) does not allow trading venues to require co-location services to be purchased in a package with other services. Article 2 of RTS 10 provides details regarding the transparency requirements trading venues should fulfil regarding co-location services, ie disclosure of list of services, fees, conditions, procedures and requirements. 8.26 Separately, to minimise the risk that an HFT firm poses through the submission of multiple speculative orders, MiFID II requires trading venues to impose order to trade ratios (OTRs), which therefore restrict the flooding of venues with orders without genuine trading intention. There is a very significant divergence in terms of maximum limits allowed across different trading venues, which is probably explicable as OTR limits are linked to the level of electrification and sophistication of the trading platform, the instruments traded and the type of trading system operated.

DIRECT ELECTRONIC ACCESS 8.27 As mentioned above, HFT enterprises often use direct electronic access to venues through existing trading venue members (ie brokers). It would normally be beneficial to HFT enterprises to be direct members without any intermediary between them and the trading venue, as the infrastructure of 118

Direct electronic access 8.30 the intermediary often introduces additional latency, which is detrimental to their ability to operate fast. This latency is not simply the result of added ‘cable’ length, but also of the operation of the trading control infrastructure of the member/broker, as seen below in para  8.46. However, membership of an exchange can be rather expensive to maintain and therefore is not accessible to smaller enterprises, such as HFT firms. They therefore use ‘direct electronic access’ (DEA), although this service is also made available by exchange members to any of their clients – not just HFT clients – as long as the exchange member has the appropriate infrastructure. From a regulatory perspective, MiFID II defines DEA as an arrangement where a member or participant or client of a trading venue permits a person to use its trading code so the person can electronically transmit orders relating to a financial instrument directly to the trading venue and includes arrangements which involve the use by a person of the infrastructure of the member or participant or client, or any connecting system provided by the member or participant or client, to transmit the orders (direct market access) and arrangements where such an infrastructure is not used by a person (sponsored access) (Art 4(1)(41) of MiFID II). The definition distinguishes between two flavours of DEA, – direct market access (DMA) and sponsored access – depending on the level of intervention by the DEA provider on the flow. These two concepts are further analysed below. 8.28 The main differentiating factor of a DEA provider versus any other broker is the lack of discretion. The broker has no ability to alter the client’s order, to divide it into child orders, to direct it into different venues, to decide on the right time to submit those child orders on a venue. All of these functions are retained by the client. The broker simply provides the technological pipes. The minute it takes back any decision making about optimal execution strategy from the client, the arrangement ceases to be DEA. 8.29 In addition, Article 21(4) of Commission Delegated Regulation (EU) 2017/589 6 (RTS 6) introduces the concept of sub-delegation by referring to: ‘[A] DEA provider allowing a DEA client to provide its DEA access to its own clients (“sub-delegation”) […]’. Sub-delegation is essentially a DEA provider plugged into another DEA provider that is a member of an exchange. The reason for these chains of DEA providers is often the presence of licensing restrictions in each jurisdiction. For instance, an HFT enterprise located in the US that would like to access an EU trading venue would optimally access such venue directly. However, there are possibly two obstacles: (1) the EU  venue may require members to be authorised investment firms or credit institutions in the EU, a condition which is quite common and cannot be satisfied by an overseas entity; or (2) the economic reasons associated with venue membership (execution, clearing and settlement costs) mentioned above. 8.30 In those circumstances, the HFT firm would seek the second ranked optimal option for its purposes, to access such venue through a DEA broker. An EU DEA broker, that is itself a direct member of the EU trading venue, would not be able to offer brokerage services in securities to a US domiciled HFT enterprise, if any of these securities could be deemed US securities, as it would fall foul of US licensing requirements. The EU DEA broker can offer services to the HFT enterprise through a US broker domiciled in the US. If that US broker uses the same non-discretionary technology, it is called a sub-delegated DEA provider. 119

8.31  Electronic trading

Figure 8.1  Direct electronic access

8.31

In respect of sub-delegation, Article 21(4) of RTS 6 provides that:

‘A DEA provider allowing a DEA client to provide its DEA access to its own clients (“sub-delegation”) shall be able to identify the different order flows from the beneficiaries of such sub-delegation without being required to know the identity of the beneficiaries of such arrangement’. 8.32 When a person accesses a trading venue using DEA, the exemption from authorisation as investment firm for persons only dealing on own account under Article 2(d) of MiFID II is no longer available to that person. Separately, DEA providers must be authorised as investment firms or credit institutions under Article  48(7) of MiFID II and cannot operate under the equivalence regime for third-country firms. Furthermore, DEA providers must comply with additional organisational requirements. However, as discussed in Chapter 2 on authorisation, MiFID II does not apply to third-country firms that do not operate through a branch in the EU. The requirements applicable to third-country firms having DEA to EU trading venues is therefore left to national discretion. Thanks to the fact that the US HFT enterprise is not domiciled in the EU, it would not be required in all likelihood to be authorised in the EU, even if MiFID II says so on the basis of its activity.

DMA 8.33 In figure 8.1 above, the trading venue is required to have a number of controls to ensure that there is an orderly market. For instance, trading venues have volatility breaks, which are triggered when the price of a stock fluctuates wildly, thereby causing trading to be suspended momentarily. They also have size controls to avoid ‘fat finger’ errors by traders who submit an order having a few zeros added by accident on the back of the number. There are detection mechanisms for algorithms which malfunction by submitting multiple identical orders. In addition, they try to detect whether the same member has placed a buy and a cancelling opposite sell order in the same stock (what is called a ‘wash trade’) which could signify an abusive behaviour. 8.34 Similar controls are also required of exchange members. They have to ensure that their clients trade within the credit and size limits they have imposed on them, depending on the credit worthiness and the trading profile of the client. They also have to identify any client behaviour which looks potentially abusive and prevent it. The control framework for automated trading exists in a firm’s own automated trading systems, its own infrastructure. The operation of these controls means that the DEA activity is considered DMA as the client orders come through the member firm’s infrastructure and then they are submitted to the exchange by the firm. 120

Risk control framework 8.38

Sponsored access 8.35 By contrast, venue members that would like to attract customers with the highest speed/lowest latency needs may develop a strategy to provide services by merging their control systems with those of the trading venue. Brokers that are members of trading venues can observe their regulatory obligations through reliance on the trading venue’s own systems, which can be configured to the specification of members. This approach obviates the need for two layers of controls but evidently reduces the opportunities for the controls to block errors or misbehaviour by clients. These arrangements still fall within the DEA definition but are considered sponsored access and allow the client more control over the order and much higher speed of execution than in DMA. 8.36 Another limitation of sponsored access is the fact that the venue controls may not be quite as detailed as the controls that could be used by the firm for the purposes of its own infrastructure. Investment firms therefore would not always offer sponsored access to all venues, even if they engage in principle in that activity.

SMART ORDER ROUTER 8.37 A particular type of algorithm that is used for the purposes of placing orders on different venues is the smart order router or SOR. The SOR is an algorithm that is often added at the end of other algorithms in any event, as the last stage of any decision making is the decision regarding the optimal trading venue on which the child order has to be placed. SORs have their own algo IDs and are a key component of any broker’s electronic trading offering. The existence of a SOR in the flow of an order is an indication that the order is not being submitted on a DEA basis, although the SOR should actually be performing a function rather than allowing the orders passively through. To the extent that it does the latter, then the connection could still be  DEA.

RISK CONTROL FRAMEWORK 8.38 The organisational requirements applicable to a firm operating an algorithmic strategy are entailed in RTS 6 which elaborates further the conditions with which firms engaged in algorithmic trading have to comply, pursuant to paras 1 to 6 of Article 17 of MiFID II: •

Article  17(1) of MiFID II requires an investment firm that engages in algorithmic trading to have in place effective systems and risk controls suitable to its business, to ensure that its trading systems are resilient and have sufficient capacity, are subject to appropriate trading thresholds and limits and prevent the sending of erroneous orders or the systems otherwise functioning in a way that may create or contribute to a disorderly market.

•

It also requires that the control infrastructure of such a firm ensures compliance with MAR and with the rules of any trading venue to which it is connected. 121

8.39  Electronic trading •

Finally, the investment firm should have in place effective business continuity arrangements to deal with any failure of its trading systems and should ensure its systems are fully tested and properly monitored to ensure that they meet the requirements laid down in this paragraph.

8.39 RTS  6 further specifies in detail the testing and deployment requirements for each algorithm, the organisational requirements of algorithmic trading firms and the annual self-assessment that an algorithmic trading firm has to produce: • Prior to the deployment or substantial update of an algorithmic trading system, trading algorithm or algorithmic trading strategy, an investment firm should establish clearly delineated methodologies to develop and test such systems, algorithms or strategies (Art 5 of RTS 6) • The firm must ensure that the algorithmic trading system, trading algorithm or algorithmic trading strategy: (a) does not behave in an unintended manner; (b) complies with the investment firm’s obligations under this Regulation; (c) complies with the rules and systems of the trading venues accessed by the investment firm; (d) does not contribute to disorderly trading conditions, continues to work effectively in stressed market conditions; and (e) operates a ‘kill switch’ (switching off of the algorithmic trading system or trading algorithm). 8.40 Article 5 of RTS 6 also requires an investment firm to adapt its testing methodologies to the trading venues and markets where the trading algorithm will be deployed and specifies when the investment firm is required to undertake further testing. 8.41 In a similar vein, Article 7 of RTS 6 sets out the expectation that an algorithmic trading firm should conduct testing to ensure compliance with the criteria laid down in Article 5(4)(a), (b) and (d) and that such testing is undertaken in an environment that is distinct from its production environment and used specifically for the testing and development of algorithmic trading systems and trading algorithms. Testing algorithms in a production environment can be risky from a market stability perspective; at the same time, the requirement to do so in a testing environment is not always easy to satisfy as venues do not always offer testing environments, or those testing environments may not be reflective of the conditions in the production environment. In any event, the algorithmic trading firm may use its own testing environment, or a testing environment provided by a trading venue, a DEA provider (if the algorithmic trading firm is a DEA client) or a vendor. None of these provisions absolve an investment firm from retaining full responsibility for the testing of its algorithmic trading systems, trading algorithms or algorithmic trading strategies and for making any required changes to them. 8.42 One of the key decisions for an investment firm is to determine when it is in possession of a new algorithm, considering most algorithms are an evolution of some existing technology. In the ordinary course of business, algorithms are constantly being tweaked to ensure their optimal function. At what point do enhancements to an algorithm constitute sufficient change to render the algorithmic strategy ‘new’, thereby triggering the testing requirements set out 122

Future proposals 8.46 above? The legislation is silent on this topic, but market practice has veered into determining an algorithmic change to be of sufficient importance if that would trigger the marketing of an algorithm as a new instance of an existing offering to the firm’s clients. Clearly, this principle relies heavily on the judgment of each firm making this determination, but it at least sets a boundary, by requiring that a firm should not be in the business of marketing an algorithm as a product if it has not tested that version in line with RTS 6. 8.43 Moreover, according to Article 6 of RTS 6, an investment firm should test the conformance of its algorithmic trading systems and trading algorithms with the system of the trading venue and with the system of the direct market access provider in a number of cases. Such conformance testing should verify whether the basic elements of the algorithmic trading system or the trading algorithm operate correctly and in accordance with the requirements of the trading venue or the direct market access provider. It is further specified what the testing should verify for this purpose. 8.44 Testing of algorithms is not a one-off event – there are ongoing obligations too, which ensure that the firm retains systems and controls applicable to the technology. One of the key requirements introduced by MiFID II is the need for an annual review of the systems and controls operated by the firm (a validation exercise) and an attestation by the firm. Such attestation is provided to the firm’s leadership, with clear lines of accountability for each component of the requirements (Art 9 of RTS 6). In the course of that validation process, the firm is required to review, evaluate and validate: •

its algorithmic trading systems, trading algorithms and algorithmic trading strategies;

•

its governance, accountability and approval framework;

•

its business continuity arrangement; and

•

its overall compliance with Article 17 of MiFID II, having regard to the nature, scale and complexity of its business.

8.45 Lastly, on testing, Article 10 of RTS 6 requires that an investment firm, as part of its annual self-assessment, tests that its algorithmic trading systems and its procedures and controls can withstand increased order flows or market stress. A firm should be able to cope with double the volume of messages compared to ordinary market conditions (Art 9). Depending on the complexity and size of the firm, the tests should be designed accordingly. A degree of proportionality is allowed, with a high burden placed on sophisticated firms facilitating significant volumes. Care has to be taken by the investment firm to ensure that the tests are carried out in such a way that they do not affect the production environment.

FUTURE PROPOSALS 8.46 As part of its regular review of elements of MiFID, ESMA launched at the end of 2020 a consultation regarding the implementation of the algorithmic trading regime and sought evidence on its function along with proposals for its improvement. (ESMA 70-156-2368,18 December 2020). ESMA is expected to analyse the results of the consultation in the course of 2021 and make proposals to the European Commission on the review of MiFID and the need to amend the legislation with regard to its algorithmic trading provisions. 123

8.47  Electronic trading 8.47 ESMA is uncomfortable with the disparity of treatment of DEA versus HFT firms in respect of authorisation. DEA firms are required to be authorised in the EU; by contrast, HFT firms are only required to be authorised in the EU if they are established there. The lack of a harmonised EU regime for thirdcountry firms also creates an uneven playing field across EU trading venues, because third-country firms using HFT techniques and/or seeking DEA access are more attracted to trade on trading venues where national rules do not require them to be authorised as an investment firm. ESMA notes that a similar uneven playing field issue does not arise with respect to the provision of DEA as trading venues may only permit members or participants to provide DEA where they are authorised under MiFID II or under CRD. ESMA is of the view that the difference of treatment appears unjustified considering that, from a risk perspective, there is no major difference between the activities of EU or non-EU HFT firms or DEA users. Those risks are related to the trading technology used rather than the location from where the activity is undertaken. It is therefore questionable whether the MiFID II regime delivers on its objective to address the risks arising from trading technology developments and to prevent disorderly trading conditions on EU markets by failing to include third-country firms. 8.48 ESMA also proposes to expand the requirements founds in RTS  6 regarding algorithmic trading governance, to cover OTC trading and in particular SIs. The requirements are currently drafted on the basis of the need for algorithms to conform to market standards; there is therefore reference to algorithms accessing trading venues and ensuring compliance with venue rules. It remains to be seen how OTC trading would be addressed in a future iteration of RTS 6. 8.49 In addition, ESMA believes that the notification of algorithms to NCAs is not currently uniform with significantly diverging standards and it therefore proposes the development of notification templates within RTS  6 that investment firms would use, for the purpose of Article  17(2) and (5) of MiFID II, to notify the NCA of their home Member State and the NCA of the trading venue at which they engage in algorithmic trading. In addition, ESMA would in particular consider it beneficial to clarify what it means to test on ‘disorderly trading conditions’. There currently seems to be no convergence in how the testing of disorderly trading conditions is done. ESMA believes that a clear definition of ‘disorderly trading conditions’ could in part contribute to a more accurate and improved testing. ESMA considers that disorderly trading conditions should refer to a market where the maintenance of a fair, orderly and transparent execution of trades is compromised. 8.50 Considering the various Level 2 regulations (including RTS 6, RTS 7, RTS 8) for which the definition of disorderly trading conditions would be used, ESMA would prefer to have a single definition of disorderly trading in Level 1 (the main legislative test of MiFID II). 8.51 In terms of the annual self-assessment, ESMA believes that there is merit in having this self-assessment shared with the NCA of the firm producing it. Apparently, this expectation, although not in the legislation, has already been set by some NCAs which habitually request the self-assessments for review. According to ESMA, NCAs who follow this practice, believe that it is a good tool but note that the lack of clear guidance and the free format of the selfassessment create very different outcomes in the level of detail of the submitted self-assessments. ESMA is therefore suggesting two enhancements to the self124

Future proposals 8.51 assessment process: first, the creation of a template for self-assessment that should be followed by every algorithmic trading firm in the EU and, secondly, the introduction of a requirement to provide such self-assessment to the NCA, in every EU Member State. This would allow NCAs to compare outcomes.

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9 Best execution

This chapter covers: • the regulatory approach to best execution; • the practical reality of the ability to provide better execution; • when the best execution duty is owed; • the approach applicable to bilateral trading; • the challenges that the application of best execution to algorithmic trading entails; • monitoring programmes; and • best execution reporting

INTRODUCTION 9.1 The concept of best execution has developed over several years to provide protection to clients of brokerage firms where a possible gap in client protection can be identified: legally, a strict fiduciary duty does not apply to the services provided by the broker to their clients. Another concept had to be invented, however nebulous, to ensure that brokers, when executing transactions on behalf of clients, prioritised their clients’ interests above their own. An example of such a conflict of interest could arise where a broker decides to execute an order for a client on trading venue A, even though trading venue B would have offered the client a better price, and the reason for the broker’s preference is that venue A offers lower access fees to the broker than venue B. If the broker adhered to best execution, the broker would not be allowed to choose venue A simply because it served its own interests better. 9.2 Further to brokerage, the concept has been expanded to apply to portfolio managers too, sitting separately from any fiduciary duty they may owe. In the case of portfolio managers, it is understood as a duty to select the brokers whose services they engage on the basis of the execution quality they deliver rather than other extraneous incentives (see para 5.7 above). 9.3 First introduced by the UK FSA in the Conduct of Business Rulebook, a duty to provide best execution was then included in MiFID I in 1994, drafted in a similar fashion to the pre-existing UK obligation. A further iteration took place in 2014 when the FCA conducted a Thematic Review in the UK (TR14/13, July 2014), finding significant deficiencies in the way the best execution duty had been implemented by the industry (see Timeline below). The publication of the Thematic Review results and subsequent updates to the fundamental 127

9.4  Best execution concept in the implementation of the MiFID II legislation have led to the current understanding of best execution that is explored further in this chapter.

Timeline 2004: 2007: 2007: 2014: 2014: 2016: Jan 2018: Apr 2018: Jun 2018: Apr 2019:

MiFID I Level 1 Text agreed CESR guidance on best execution under MiFID I MiFID  I  comes into force: pan-European duty of best execution TR14/13: FCA report on best execution MiFID II  Level 1 Text agreed: duty of ‘taking sufficient steps’ MiFID II Level 2 Text agreed to best execution reporting MiFID II comes into force First ‘best efforts’ RTS28 reports are published First RTS27 reports are published for first quarter of 2018 First ‘tactical’ RTS28 reports are published

BEST EXECUTION DEFINITION: THE ‘SUFFICIENT STEPS’ STANDARD 9.4 The rule currently applicable to all EU and UK investment firms is that ‘a firm must take all sufficient steps to obtain, when executing orders, the best possible result for its clients taking into account the execution factors’ (Art 27(1) of MiFID II). The term ‘sufficient steps’ was updated in MiFID II from ‘reasonable steps’ in MiFID I to encompass the relatively higher standard that had been set out in the Thematic Review of the FCA. ESMA clarified in its Investor Protection Q&A  (Q1 of ESMA35-43-349) (available at: www.esma. europa.eu/sites/default/files/library/esma35-43-349_mifid_ii_qas_on_investor_ protection_topics.pdf [accessed 5  August 2021]) that ‘sufficient steps’ as a term is likely to involve the strengthening of front-office accountability and systems and controls. Firms ought to have systems which have sufficient ex-ante controls (well-designed policies) and ex-post controls (monitoring programmes) and a feedback loop that allows the policies to adjust to the effectiveness of the execution quality as observed by the monitoring programme. ESMA also requires escalation to senior management through internal reports. 9.5 The execution factors referenced in the definition of ‘best execution’ and which are required to be considered by the firm are defined as ‘price, costs, speed, likelihood of execution and settlement, size, nature or any other consideration relevant to the execution of an order.’ An example of applying the execution factors appropriately would be the case of two different clients who want to purchase the same amount of shares in Company X. Client A  would like to have the shares as soon as possible and has indicated this preference 128

Is the duty of best execution absolute? 9.6 by submitting an order type called ‘Immediate or Cancel’ or IOC. Client B on the other hand is Mr Smith who has submitted an order with a price limit of £1, meaning that he would not want to pay more than £1 per share. A broker, applying best execution for Client A, would scan the prices available across all venues almost immediately after Client A submitted the order and, without hesitation, place the order for execution at the cheapest venue. This means that speed of execution has been correctly prioritised in line with the client’s wishes expressed in the order type. On the other hand, Client B was rather interested in obtaining a favourable price and in fact, had that price not been available on the market, Client B could have happily walked away without any transaction. If the broker followed the same execution logic as for Client A, there would be a high likelihood that the broker would have failed Client B in terms of best execution, unless –through happenstance – the price at the immediately available venue happened to be better than £1 per share. A broker providing best execution to Client B  would still aim to get the better price for their client but within the confines of what the client has requested. Therefore, if there are three venues trading this security and all three of them have prices higher than £1, the broker simply has to wait. Normally the broker will impose through terms of business a time limit on the duration of the order, so that there is a clear time by which the broker is no longer liable to the client for the execution. Assuming this is a ‘day order’, the broker will have to wait until such moment within the normal trading hours of the venues trading that security and be ready to execute at the exact moment that the price moves at or below £1. In the example of client B, it is price that is the execution factor with highest priority. Speed is still relevant (without being dominant), as any delay and the price could move higher again, missing the opportunity to execute.

IS THE DUTY OF BEST EXECUTION ABSOLUTE? 9.6 The Client B order offers an opportunity to look at different permutations of the same scenario in greater detail. What if the price continued to fall through the day and, having crossed the £1 mark by 1pm, it had hit by the end of the day a new low of £0.8? Would Client B, having received the prevailing price at 1pm, be justified in believing their broker had failed them in their duty of best execution by not getting the best price of the day? The answer is that the broker does not have an absolute obligation to give the best price of the day, only a price that is at or below the price requested by Client B. In fact, the broker could have inadvertently given Client B a better price, if the broker were remiss and delayed in getting the £1 price by several minutes or hours. The broker would have failed Client B  in terms of the legal duty of best execution even though in practice Client B would get a better price in effect and should therefore theoretically be even more satisfied, as price was the top execution factor for them. The point of this example is that execution factors are not viewed in total isolation; they co-exist, but are ranked in a relative fashion. In this example, the best way to express the goal of the client is ‘a price at or better than £1 per share in a timely fashion’. Brokers are used to interpreting order types in a way that translates into a series of basic logical principles, especially as they often have to parse that interpretation into electronic code to facilitate electronic trading. The bad outcome for Client B  (irrespective of the better price) can be demonstrated even more starkly, if Client B had a contingent obligation to another party, for instance under a derivative transaction, that required timely satisfaction as soon as the price of that security reached at or below £1. Any delay by the broker 129

9.7  Best execution of Client B, however benevolent in its price outcome, could have ultimately compromised the ability of Client B to satisfy their own onward obligation. In practice, a client receiving a better price through inadvertent delay would rarely complain about non-delivery of best execution, unless there is such a follow-on obligation or the timely execution were part of a broader trading strategy that was therefore compromised.

BETTER OR BEST? 9.7 In the days of electronic trading, a client requiring speed, such as Client A in the example above, may legitimately expect their execution to take place in microseconds, or sometimes in nanoseconds. Can one possibly expect all brokers to execute at the exact same maximum speed to satisfy best execution? At a time when innovation in electronic trading continues to accelerate, there is always a range of outcomes in speed depending on the technological capabilities of a firm. Another example can be sourced from multi-venue trading: most securities are traded in multiple venues. If there are ten venues on which that same security is traded and the broker is only a member of eight of those, does it matter if it misses cheap liquidity that may exist in the two trading venues to which it is not connected? At the end of the day, in both of the examples above, the clients will vote with their feet and move to brokers who have better technology and more comprehensive connectivity. This is the reason that makes business people often think of best execution as a self-policing concept rather than one that requires regulatory intervention. Clients, especially the more sophisticated ones, would normally be driven by their own commercial interests to avoid brokers that give them poorer outcomes. Similarly, brokers would be driven by profit to provide the best services possible and maintain their market share. Although this is not completely invalid as a point – client pressure is indeed the biggest driver for improvement in brokerage services – it does not reflect the underlying objective of the regulatory obligation, which is to maintain pressure on firms to prioritise their client interests in a complex trading landscape – always within what is possible through their existing infrastructure – and to ensure that they continue to refine that logic through review and introspection. In that sense, it is an obligation to strive for better execution rather than best. 9.8 Perhaps uniquely amongst conduct of business rules, best execution has a huge body of obligations implicitly derived by the rule rather than explicitly stipulated in the rule book. Regulators and the industry have understood the obligation to mean that firms have to: •

identify the asset classes and types of execution patterns on which the firm offers best execution;

•

provide details of that assessment, with clarity, in their internal best execution policy and in the summary of that policy that firms publish to their clients;

•

maintain a monitoring programme reviewing the effectiveness of their execution strategy in the businesses where they owe the best execution obligation; and

•

have a governance structure, through committees or working groups, to ensure that the monitoring programme is fit for purpose and that any exceptions or systematic issues are addressed in a timely fashion.

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When is best execution owed? 9.12 9.9 This framework tries to put best execution, a concept often difficult to pin down, into a more demonstrable standard, one that forces firms to strive to provide always better execution.

WHEN IS BEST EXECUTION OWED? THE EVOLUTION OF THE BEST EXECUTION CONCEPT FROM EQUITIES TO ALL ASSET CLASSES 9.10 Executing orders on behalf of clients is the most frequent form of execution in equities trading. For instance, all the examples given above would relate to equities traded on one or more trading venues. Taking an order from a client and placing it on a trading venue for execution is what is called ‘agency trading’ amongst trading circles. In this case, ‘agency’ does not mean legal agency, in the sense that no contract is formed between the client and the venue through the intermediation of the broker; instead, it is a term of art to explain that the broker is acting on behalf of the client. In truth, the capacity of the broker would be both as principal counterparty to the client and principal counterparty to the market, simultaneously settled (what is called ‘riskless principal capacity’). In that sense (in the limited nomenclature of trading) agency and riskless principal are often used interchangeably. The word ‘agency’, however loose in this context, gives us a clear understanding that a client who wants to buy or sell shares into the market and instructs a broker to do this in an agency capacity (ie as an intermediary to the market) has every right to expect delivery of best execution by that broker. 9.11 When a firm executes transactions with or for clients in asset classes other than equities, it is far less likely at present to use agency-style execution, due to existing market structure issues. Generally speaking, fixed income products, such as bonds, as well as foreign exchange, commodities and derivative products are not traded frequently on exchanges or other trading venues. Although there is effort in regulation to push certain of these products to trading venues and mandate that regulated firms trade them only there (see para 7.25), in truth the vast majority is still traded by dealers who possess inventory in these products and are able to provide clients directly with the exposure they need by trading on a bilateral basis or – as commonly called – in the OTC market or as an SI. 9.12 As firms act bilaterally or as a counterparty to the client, they do not trade ‘on behalf’ of a client and therefore are not viewed as executing orders. Therefore, best execution has traditionally not been viewed by market participants as applicable in these cases. In fact, US regulation does not require best execution to be applied to these asset classes. With respect to derivatives, the US Commodity Futures Trading Commission (CFTC) and the National Futures Association (NFA) do not have specific rules governing best execution and fair commissions, other than with respect to security futures contracts. However, in Europe there has been guidance since the implementation of MiFID I, provided by CESR (Extract from Commission Opinion on the scope of best execution under MiFID and the implementing directive: Working Document ESC-072007), indicating that there are cases, even in these bilateral trades between clients and the firm, where the broker owes best execution. This guidance was not well understood by the market and according the FCA TR14/13 it had not been implemented properly by 2014. The FCA reiterated (and some argue altered) the concept in the results of its Thematic Review. 131

9.13  Best execution

THE CESR/FCA GUIDANCE ON WHEN BEST EXECUTION APPLIES IN BILATERAL TRADING 9.13 The main question in the guidance is whether the client places reliance on the firm. Reliance by clients would normally give rise to the duty of best execution in the investment firm facilitating them. In the case of retail clients, their reliance on the firm is presumed, largely because they are viewed by regulators as less sophisticated or unable to look after their own interests. By contrast, professional clients and eligible counterparties (ECPs) are presumed to place no reliance on the firm, as regulators expect them to have resources to protect their own interests.

The four-fold test The criteria on the basis on which a presumption of best execution can be affirmed or negated are known as the ‘four-fold test’: (1) Which party initiates the transaction: has the client initiated the transaction by requesting a quote? (2) Questions of market practice and the existence of a convention to ‘shop around’. (3) The relative levels of price transparency within a market. (4) The information provided by the firm and any agreement reached.

9.14 Unfortunately, the commentary the FCA provided under each of these headings related to prevailing practices they wanted to criticise at the time and did not explain how they would expect each of these factors to be implemented. In addition, the commentary shows confusion as to what each of these factors mean: in factor 4, the presumption that retail clients are always reliant on the firm for best execution is cited as an example of firms providing a good level of information, whereas that is something pre-existing in the legislation on which firms have no discretion. On factor 1, firms are criticised for excluding clients when dealing on quotes, which should be linked as a practice to factor 2. The confusion is further compounded by the FCA expecting all four factors to be taken into account cumulatively, a concept which was never present in the Commission’s original guidance and can be difficult to implement in practice as explained in para 9.19 below. In essence, the Commission expected each of these factors to be taken as indicia and to be reviewed as appropriate, not necessarily in tandem. 9.15 But what do each of these factors mean? The first factor is the hardest to comprehend. It can be argued that when a firm approaches a client and proposes a product to them, it should provide a higher level of protection to that client as it is – in a sense – proposing that product to the client and the client will have relied on the firm taking all steps in assessing the suitability of that product to them. It would be paradoxical if a firm called up a corporate client that is an airline operator and offered them an oil future as a hedge to the company’s fuel price risk exposure, but somehow that initiation meant that the firm did not have to design the hedge in a way that it provided the protection promised to the client. One would expect best execution to apply in such case. But what if 132

The CESR/FCA guidance on when best execution applies 9.18 the airline operator calls up the broker and asks for assistance in formulating such a hedge? Again, it would be hard to argue that the client does not need best execution protection there. The better view is that factor 1 can only be understood in conjunction with factor 2. If the client is simply responding to a stream of standardised quotes provided by the firm, and such streams of quotes in the same product are available by other firms, then it is more likely that the client has made the decision to opt for the firm’s quote on its own accord and does not rely on the firm providing the quote for best execution. However, factor 1 cannot diminish the impact of factor 4, ie  if a firm has provided a tailored quote for a client upon the client’s request, that should not remove the firm’s best execution obligation. In fact, if a tailored quote is provided by the firm as part of a derivative transaction designed by the firm, the agreement reached between firm and client could be informative; it may provide the client with sufficient information as to how the execution should take place. In that latter case, the client expects the firm to comply with the terms of the agreement as a means of the firm’s delivery of best execution. This demonstrates that factor 1 can imply best execution in both directions (the client or the firm initiating the transaction), dependent on the specifics of the interaction as interpreted by factors 2 and 4. 9.16 Factor 2 also uses the term ‘market practice’ which would normally allow a firm to consider what is typically the case in the market without having to check what the client has done in that particular interaction. For instance, in the government bond market, it is typically the case that the same government bonds are traded by a number of broker/dealers who are providing competing prices in those instruments. These are often the same firms that act as ‘primary dealers’ in those instruments, which means that they have an arrangement in place with the issuing Debt Management Office of that sovereign government to take allocations of those bonds and place them in the market, ie with the investing public. These broker/dealers are each a separate source of liquidity in the same instrument (in this case, the same government bond) and in competition with each other. They stand ready to fulfil client requests to trade. The convention in the market is for clients to ask a small number of them (usually three) their price in that instrument and in the size the client wants and then for the client to go with whichever liquidity provider they believe offers the best price. So well established is that convention, that – rather atypically – regulators would allow firms to take it for granted that their client has ‘shopped around’ for a price. It would be impossible for firms to check whether this ‘shopping around’ has actually happened, without asking the client awkwardly at the time when they are approached to trade. Firms can therefore take such asset classes out of their best execution obligation and be explicit to their clients that they are not providing that protection to them. 9.17 Other than government bonds, other assets that would fall within that ‘shopping around’ convention and can legitimately be taken out of the best execution obligation include certain liquid corporate bonds, foreign exchange products (futures and options on currencies) and certain vanilla interest rate products. 9.18 Finally, it would be important to address factor 3, the relative levels of transparency in the market. The investing public has increasingly broad access to information that allows it to assess the merits of a price. One can find, for instance, the prevailing wholesale exchange rate for major currencies through a mere internet search. The same is true for shares traded on exchange. Their prevailing price is provided for free, after a short delay, to the general public 133

9.19  Best execution on the exchanges’ website and through internet search engines. Clients that are themselves professional would pay for access to this information and would receive it in a timely way allowing them to assess whether the price offered to them by their counterparty is in line with prevailing market conditions. It would not be appropriate therefore that bilateral trading in asset classes of that nature would imply a duty of best execution for the firm. However, even in these cases, if the size of the trade is large, the prevailing market prices are not an appropriate benchmark and normally the firm would be expected to monitor the quality of execution for outsized trades.

CHALLENGES IN THE OTC MARKETS 9.19 The debate about bilateral trading brings us to the question of what best execution actually means for OTC markets, such as the derivatives markets, in cases where it actually applies on the basis of the four-fold test. Is this a pricing race to the bottom? Are regulators expecting firms to forego their profits on bilateral trades? There seems to be no indication that this is the case. Financial regulation in Europe is not concerned with price regulation. Still, does it mean that a firm simply has to be the cheapest possible source of liquidity? Surely, regulators do not expect firms to compare prices to beat the cheapest price in illiquid products, as such comparison would require exchange of information that would be contrary to competition policy. If it is not about price, then what are the features of a trade that would demonstrate best execution over worse execution? This is probably the most vexed question in the implementation of best execution. 9.20 Some firms have simply decided that this question belongs to the ‘too difficult’ bucket and have opted to clarify to their clients that they should not rely ever on them for best execution on bilateral trades. Aside from the fact that the FCA had explicitly criticised that approach in TR14/13 (p  20), it is simply incorrect to assume that disclaiming best execution gets the firm out of the obligation altogether. Market participants pursuing this strategy confuse disclosure with disclaimer. The regulation does not allow a firm to derogate from the obligation through disclaiming it. But it does require firms to apply best execution across their trading systems and to disclose to their clients how they have actually interpreted the obligation. Instead of giving firms the option to communicate to clients that the obligation is inapplicable, the regulation applies a double lock of protection: the firm has to apply it reasonably and then, in addition, it has to explain it to clients, so that they can be aware of the arrangements and decide which firms are better at looking after their interests. 9.21 If it is incorrect to disclaim best execution on bilateral trades, then the only approach one could take is twofold. For single asset trades, for instance outsized blocks in an oil future, the firm would have to look at comparable executions over a period of time, establish a median of profit and loss and assess reasonableness of price and other execution factors. This, of course, is not easy, especially as there may not be sufficient precedents for similar transactions; for complex trades, one would have to break them down into their constituent parts for assessment of the underlying assets. A derivative transaction tracking a basket of shares would have to be assessed on the basis of best execution of the underlying shares (even though those transactions are principal hedges of the firm and are not executed on behalf of the client) and any risk premium that may have been agreed with the client. 134

Challenges in applying best execution to algorithmic trading 9.24 9.22 Unfortunately, this approach, although close to the spirit of the rules, creates a myriad of problems in automated monitoring programmes. The approach requires judgement that is not easy to codify. Some automated programmes therefore err on the side of caution, whereas others tend to oversimplify, thereby reducing the number of exceptions generated (see below under Monitoring programmes).

CHALLENGES IN APPLYING BEST EXECUTION TO ALGORITHMIC TRADING 9.23 As trading has evolved to encompass electronic modes of execution, the prevalence of electronification means that best execution must, more so than ever before, be assessed in the context of complex decision making. 9.24 If we take one of the early examples in the chapter, a firm that receives an order for 100 shares from a client and submits it for execution to a trading venue makes that decision on the basis of an assessment of which trading venue is the more effective in providing the client with the type of execution that it needs based on the client’s preferred execution factors (speed, price etc). To illustrate this example, see figure 9.1.

Figure 9.1

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9.25  Best execution 9.25 This decision, which in the past would have been made over the telephone or over a terminal, is now made electronically. In fact, in all likelihood, there would be no human beings involved in the receipt of the order, the venue decision, or the execution itself. Instead, a smart order router (SOR) operated by the brokerage firm, as seen in para 8.37, would receive the client order and, on the basis of market data it continuously receives from the trading venues themselves, the SOR would decide in which of these venues the order should be executed. For an order as small as 100 shares, one would expect the order to be satisfied through a single execution on the market. In figure 9.1 it has chosen VENUE C, an MTF which had the best price for this size of order. This is a simple example where it can be said that the client has relinquished their discretion on how the order should be executed by entrusting it to the brokerage firm. The firm therefore owes best execution to the client in respect of that single order and has sought to provide best execution on it. Things get more complicated when a more complex algorithm is engaged. By way of contrast, see figure 9.2 below.

Figure 9.2

9.26 An SOR is a simple type of algorithm itself and it would be used in almost every electronic execution in shares. But further to the use of the SOR, the client could submit an electronic order using an algorithm. For example, the client has submitted an ‘agency day VWAP’ order in 100,000 shares in company 136

Challenges in applying best execution to algorithmic trading 9.27 X. This overall order is called a ‘parent order’. On the basis of the form of order the client has submitted, the firm understands that the client has predetermined that it would like to receive 100,000 shares in company X, but it would like the overall price at which it buys these shares to reflect the volume weighted average price of that day’s market trading. By asking for agency execution, the client has not opted for any price guarantee by the brokerage firm, so the firm can aim to get as close as it can to VWAP. The client has indicated through the use of ‘agency’ that it is happy to have its order submitted to the market and participate directly in the market, aiming to get as close as possible to VWAP. Now, the client has not handed over discretion to the brokerage firm entirely, as it has stipulated that it wants the VWAP rather than the best price or immediate execution. But it has relied on the brokerage firm on how to achieve that VWAP. This is where the algorithm kicks in and tries to keep the client’s order participating in the market across the day in volumes that reflect market conditions, so that it can get as close as possible to the VWAP. In doing so, the firm owes best execution to the client in respect of the ‘parent order’ the client has submitted for the purposes of achieving its price objective. The firm’s VWAP algorithm then chops up the ‘parent order’ to create ‘child orders’ that can be submitted throughout the day in sizes representing the market volume. If there is a spike in volume at noon, one would expect the algorithm to have created one or more larger ‘child orders’ for execution at that time. A well calibrated algorithm can achieve near-perfect replication of the VWAP for the client. One should always expect some small deviation, which the client has implicitly accepted by virtue of submitting an agency order. By contrast, if the client had wanted a perfect VWAP, they would have asked the brokerage firm to provide them with a ‘Guaranteed VWAP’. This type of order provides the client with certainty and the firm simply uses its own VWAP algorithm as a means of hedging its exposure to the client, thereby swallowing the cost of any deviation between the price achieved by the hedge and the price delivered to the client, and charging a premium for providing the client with the benefit of certainty. By contrast, in an agency VWAP, once the child orders are created by the algorithm, the SOR takes over and decides the venue to which the relevant child order should be submitted for execution. 9.27 We have established that the firm needs to get to as close as possible to the VWAP in respect of the parent order to provide the client with best execution. But what about the child orders and their execution? Is there a subsistent duty to provide best execution in respect of each child order? We have demonstrated in the first example that the SOR is governed by principles of best execution. The regulators have tried to imply that every child order has to be separately subjected to a best execution test (TR14/13, p 21), but the industry has vigorously resisted this proposition. Even though the performance of a VWAP algorithm can only be improved by assessing its performance at child level, this is an internal matter for the firm and cannot be confused with owing best execution on each child order. Lapses of performance of the SOR or the algorithm would give a worse overall outcome in the parent order. For that reason, firms do submit the child orders to best execution monitoring and look for missed liquidity or ways to improve performance of execution on each child order: which venue had better liquidity or better price. In a way, that is a form of ‘internal best execution’ and can be easily confused with the formal regulatory obligation owed to the client. It is in that spirit that the industry has interpreted the FCA’s guidance that there should be an overall monitoring for algorithmic performance at child order level, but the monitoring for delivery of best execution rests at parent order level. 137

9.28  Best execution

SINGLE VENUE OR DARK TRADING MONITORING 9.28 What if the broker includes in its sources of liquidity its own principal liquidity provision? An example of that type of liquidity provision in the preMiFID II days were the broker-operated broker crossing networks (BCNs) and post-MiFID II the systematic internalisers established by both brokers and other external liquidity providers (ELPs). These are not multilateral systems, as they are intended for the provision of principal liquidity by their operators. Due to their principal nature, they do not provide transparency (through market data) regarding the depth of liquidity or how natural that liquidity is (ie how much it originates from activity with other clients of theirs). It is therefore very difficult to assess the quality of execution that they offer overall, as the SOR cannot look at the pre-trade information they publish and make an informed decision as to which of these liquidity providers offers a better price. However, these forms of principal liquidity maintain their attraction, often surpassing the appeal of exchanges and other public markets. They continue to attract interest on the basis of their ability to provide liquidity in a way that is least impactful to the client. Impact in this case means that the market could start moving against the interest of the trading client, now having evidence that there is a buyer in the market. So the tail of executions could be adversely affected. 9.29 However, if the broker does not have the means to demonstrate on the basis of market data that its own principal liquidity source is superior to other external sources, can it justifiably send client orders to its own liquidity source as a venue? This practice could possibly be ridden with conflicts of interest, as the broker is incentivised in two ways to maintain the liquidity in-house: (1) The broker avoids the costs of external execution (exchange, clearing and settlement fees) which would have not been explicitly charged to the client in any event. In an all-inclusive model, which is the model operated by most brokers, all executions are charged at the same commission rate to the client (eg two basis points of the value of the securities). However, the underlying cost to the broker is certainly not the same across the channels. At the end of the day, brokers justify a flat rate for all the execution channels on the basis that the overall cost is evened out at the end. But by preferencing the internal source of liquidity on a systematic basis, the broker reduces overall costs to itself without adjusting the commission rate paid by the client. (2) The trading desk at the firm that provides principal liquidity enhances its volume of execution and becomes an important venue that other market participants may have to take into account in their execution strategy. 9.30 To be able to achieve these beneficial outcomes for itself, the firm needs to be clear on the grounds on which the internal desks providing principal liquidity could be justifiably preferenced using the criteria of best execution. Recitals 100 and 108 of MiFID II allow firms to select a single venue of execution only where they are able to show that this consistently delivers the best possible results. 9.31 Firms would therefore have to undertake a comparative assessment, pursuant to which their own venue would be viewed as most advantageous for the clients. Of the execution factors that can provide sufficient justification in this case, the most helpful could be price, speed, likelihood of execution and settlement. 138

Reports to clients 9.34 9.32 As the order does not leave the infrastructure of the firm, the speed achieved can be optimal. Price may also be an improvement, as the price impact that the onset of the parent order will have on subsequent child orders of the same parent order on a third-party venue would be reduced when the parent order is placed efficiently on the internal venue. The reason for this is that there are usually no HFT or market making firms present on that internal venue listening out for signals and waiting to engage with the activity of other clients to their own benefit. Certainty of settlement is also higher on internal venues as the broker controls the liquidity provided to the client and, therefore, there is a lower possibility of operational errors in the settlement process. By contrast, the likelihood of execution may be lower as the internal trading desk providing liquidity is unlikely to have the depth of liquidity that a major exchange would have in the same stock with its numerous exchange members. It is therefore possible that the entire order could not be executed on the internal venue but part of the order will have to stay unfilled and cancelled so that it can be submitted externally. The process used to ensure optimal results for clients who would be interested in price impact is to place the order on the internal venue first and only execute the residual on an external venue. In conclusion, the broker may justifiably show a preference for the internal venue. However, there is still a cryptic requirement that the FCA included in its Thematic Review, which requires firms to provide their clients with the cost benefit that they themselves derive through the use of external venues. Otherwise, the flat fee structure is viewed as discriminatory against third-party venues: ‘The implications of this rule and relevant materials for our findings is that where firms directly benefit from reduced execution costs resulting from internalisation (because they charge their clients flat commission rates and do not rebate any costs saved from internalising) then they will be discriminating against other venues.’ (TR14/13, p 33) Due to the difficulty of implementing this particular observation narrowly, the industry has interpreted this as a requirement to reflect the cost reduction overall in their pricing.

MONITORING PROGRAMMES 9.33 Monitoring programmes were originally not mandated by regulation but were implemented by the industry on the basis that there was no alternative to demonstrate that the firm was compliant with its policy on best execution. In MiFID II, Recital 107 now compels firms to have such programmes: ‘[i]n order to obtain the best possible results for their clients, investment firms should compare and analyse relevant data published by execution venues in accordance with Article 27(3) of MiFID II’. The evolution of the requirement brought in scope securities financing transactions as well (securities and margin lending, repo, buy-backs).

REPORTS TO CLIENTS 9.34 Before any regulatory reporting on the quality of execution was mandated by MiFID II, the industry had already developed tools to assess 139

9.35  Best execution performance in asset classes with observable market liquidity, such as equities and bonds. The main tool used for that assessment is called transaction cost analysis (TCA). The report could be used by brokers to assess their own performance, but also at other times provided by brokers to their clients, or purchased by clients from third-party independent providers. TCA reports have been adjusted over time to incorporate elements of the pre-trade landscape (such as quality of quotes) which have been included in the MiFID II requirements, so that they can combine a regulatory and a commercial purpose. 9.35 TCAs normally look at the liquidity achieved versus the benchmark aimed by the order type, for instance VWAP, TWAP or Implementation Shortfall. They then mark the performance of the broker in terms of how close they came to the desired result. They also assess missed liquidity, ie  counter orders that the broker could have accessed to deliver a better outcome to the client, but which the broker missed either because it does not have a good enough logic implemented in its algorithms or because it is not connected at all to the venues that had that liquidity. 9.36 Apart from TCA reports, which continue to be the main commercial tool for best execution assessments there are two other formal reports, which are mandated by MiFID II: the execution quality report required by Commission Delegated Regulation EU/2017/575 (RTS 27) and the top venue report required by Commission Delegated Regulation EU/2017/576 (RTS  28). The idea was to aim to provide parity of disclosure to all clients and across all brokers and venues so that the industry can compare the provision of services and liquidity and assess the better provider.

RTS 27 reports 9.37 RTS  27 reports make public detailed information on instruments traded on systematic internalisers, trading venues and execution venues for OTC products. The report is published by all execution venues subject to MiFID on a quarterly basis. The first RTS 27 reports were published in the second quarter of 2018 and contained information in respect of the first quarter of 2018. 9.38 The report includes data on executions, as well as RFQs, quotes and orders, irrespective of whether an execution takes place. In other words, the reports are focused on both ‘addressed liquidity’, where the order has interacted with the liquidity resulting in partial or full execution, or missed opportunity, where the trading interests have not been matched. This is important, as it demonstrates that best execution is often a duty to avoid misplacing the orders and therefore avoiding bad execution. 9.39 The scope of products in these reports encompasses listed and unlisted financial instruments, but excludes spot FX, spot commodity transactions, and loans trading. The instruments to which the obligation to report applies ought to be executable on a trading venue, systematic internaliser, market maker or liquidity provider, irrespective of whether these instruments are ‘traded on a trading venue’ (in other words, are recognised as being listed on an exchange or MTF in the EU). At the time of MiFID II implementation, there was considerable debate as to the difference, if any, between the categories of ‘market maker’ and ‘liquidity provider’. This was further clarified by secondary legislation, when Recital 7 of RTS 27 indicated that ‘liquidity provider’ meant: 140

Reports to clients 9.43 ‘… firms that hold themselves out as being willing to deal on own account, and which provide liquidity as part of their normal business activity, whether or not they have formal agreements in place or commit to providing liquidity on a continuous basis.’ By contrast, ‘marker makers’ are defined in MiFID II as firms with formal arrangements for market making on a venue. As the information included in the RTS 27 report is intended for the assessment of the venue by entities that access it, it does not differentiate between data relating to interactions with eligible counterparties (where best execution is not owed) and other categories of clients. All data is of interest to those assessing the venue. 9.40 The obligation to produce these reports arises when a firm is engaged in providing execution services; this would normally be the entity employing the trader or the sales person handling the execution for the client. 9.41 RTS 27 was originally conceived as information provided by execution venues such as primary exchanges or MTFs. As it has already been shown in figures 9.1 and 9.2, firms accessing as members these primary exchanges or MTFs would normally receive live pre- and post-trade data from these venues and would therefore be able to make informed decisions in choosing the most appropriate venue for the execution of their trades. They would not have to wait for the RTS  27 quarterly report to be published for them to adjust their logic. In addition, several concepts that would normally apply to trading venues have been transposed to any firm that acts as an execution venue by the mere fact that it advances OTC liquidity (as seen in the examples above). However, while a trading venue may operate different order books or market segments, an investment firm should only be trading in any given financial instrument either in the capacity of an SI, or in the capacity of a market maker, or in the capacity of ‘another liquidity provider’. In truth, unlike trading venues, investment firms should not act in more than one capacity when trading in a particular financial instrument, so they should be reporting per financial instrument either as an SI, a market maker or ‘another liquidity provider’. RTS 27, Article 6(f) requires the publication of the median size of orders or RFQs on any given date of the report if more than one order or RFQs were received on that day. That is an important requirement for such firms that are streaming RFQs through their systems.

RTS 28 reports 9.42 RTS 28 reports illustrate the top five venues on which the firm executes client orders and provide qualitative commentary on the firm’s delivery of best execution for each class of financial instrument. The report is published by any firm that handles client orders (including portfolio managers) and is published on an annual basis. 9.43 RTS  28 reports are focused on the choice of venue that firms make; they are essentially the flipside report produced by consumers of the RTS  27 report. In both figures 9.1 and 9.2, the firm that places the orders on behalf of their clients would be subject to the RTS 28 report. The same firm could also be subject to the RTS 27 report in respect of executions provided to child orders by the firm as a systematic internaliser. As RTS 28 applies to firms in respect of their performance of best execution, it excludes any transactions undertaken on behalf of eligible counterparties; there is no best execution obligation in respect of that category of clients. RTS 28 requires investment firms to publish the top 141

9.44  Best execution five execution venues in terms of trading volumes for all executed client orders per class of financial instruments. This requires firms to classify orders as either ‘passive’, ‘aggressive’ or ‘directed’. The concept of passive or aggressive is only applicable where the order is sent to a venue that runs an order book. 9.44 Both RTS 27 and RTS 28 reports must be machine readable as they can potentially include millions of data fields.

WHAT HAPPENS WHEN BEST EXECUTION GOES WRONG? 9.45 Clients universally expect best execution but would be disappointed to hear that there is no sufficient recourse in regulation for cases where the firm has failed to deliver. This is due to two grounds: (1) there is no civil liability regime attaching to best execution; and (2) best execution is evaluated on the overall performance of the firm, not on an order-by-order basis. (By contrast, in the US, best execution is owed on an order-by-order basis: see FINRA Rule 5310.) 9.46 Ultimately, firms may be subject to regulatory enforcement for failing systematically to provide best execution, for lacking sufficient systems and controls that would enable them to ensure the performance of their duties. There may also be senior manager liability under the senior manager regime in the UK, if the regulatory breach took place under the supervision of the FCA. Firms are striving to maintain a complete audit trail of the decisions that have led to their application of best execution, the monitoring programme that has provided them with pointers on where in the firm execution quality does not look consistent and the follow-up actions they have taken to address such shortcomings. 9.47 Best execution appears much better rooted in day-to-day practice than it was in 2014, with firms performing controlled experiments to look at alternative placement strategies that would deliver better results, before deploying these new strategies in their systems.

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10 The future of market structure in Europe

This chapter will cover: • recent developments in the UK and the EU pointing to the near-term evolution of the regulatory landscape in securities; • the UK’s reconsideration of its perimeter in the aftermath of Brexit; and • the revisions of MiFID II in the EU and the UK, both short-term and longer-term, affecting market structure and access to liquidity.

10.1 The future of market structure in Europe and the evolution of securities law, although hard to predict, is showing certain very distinctive traits. The experience of Brexit as a forced bifurcation of what many thought a successful single market in financial services has been succeeded by two key forces at work. On the one hand, there is renewed momentum in the UK to develop market-friendly policies that will attract global business. This approach does not necessarily mean deregulation, albeit there are some sure signs of rule relaxation, but certainly includes innovation and dispensing with rules which may have ended up with an unwanted or unexpected outcome. On the other hand, the EU is relying on the size of its investor base in the region to argue that it is the natural location as the epicentre of financial services and to argue for relocation of liquidity and capital from the UK to the EU. This ambition has not resulted in any alterations to the cumbersome process of producing detailed primary legislation that is inflexible and often with outcomes that do not meet its objectives. At some point, these two trends will collide as regional competition will make it impossible to sustain either the risk of losing business to your neighbour or a race to more relaxed standards. We have yet to experience fully this competitive trend and to see where it will lead either side. For instance, it could allow the UK to prove that the Brexit experiment was not in vain, or it may force the EU to explore a more flexible and dynamic system of rulemaking. In this chapter, we will review some key developments in market structure that elucidate the direction of travel.

THE UK’S APPROACH TO ITS PERIMETER 10.2 HMT published its ‘Overseas Framework: Call for Evidence’ (December 2020), which was intended to review the ways in which the UK will approach incoming financial services from overseas jurisdictions in post-Brexit Britain. As seen at para 2.36, one of the most open and liberal regimes, the UK’s overseas persons exclusion (OPE), in combination with the Financial Promotions Order 143

10.3  The future of market structure in Europe (FPO), has facilitated not only the access of international institutions to the UK wholesale market but also the domiciliation of international institutions in the UK, where they can receive global financial services. The availability of uninterrupted global services from overseas providers, without raising obstacles through any requirement by the UK authorities to provide licences or equivalence determinations, stems essentially from the characteristic performance test (discussed at para  2.12). This is set out in concrete pieces of legislation (statutory instruments), rather than relying on accepted practices as in most other jurisdictions. This regime has provided major global financial institutions with the opportunity to centralise their operations for the region in the UK over other European countries. It has also facilitated the almost seamless transfer of risk between affiliates around the globe. Several institutions headquartered in a number of countries around the world have chosen their UK domiciled entities to become the centres for risk centralisation (in respect of client activity in Europe, Asia or the Americas) and efficient risk management. The foundational elements of that regime, which – in their first incarnation – date from 1986, have evolved and somewhat expanded over time. However, additional regimes were introduced in the UK as part of the UK’s implementation of EU legislation, in particular in respect of MiFID services and clearing services. The concept of equivalence, which was not part of the UK regulatory architecture in the first place, was introduced through MiFIR (Art 47), EMIR and a number of other EU regulations, amounting to several equivalence decisions in respect of incoming services, without which global financial connectivity could be disrupted. While in the EU, the UK relied on the EU authorities making these determinations. This sat uncomfortably with the domestic regime in the UK as the concept of actively approving access through equivalence determinations and not being required to approved access thanks to the characteristic performance test are philosophically opposite. With legislative autonomy being restored to the UK wholly after the end of the transition period on 31  December 2020, the UK set out to rationalise these arrangements. Although this rationalisation is still evolving, the direction of travel is for the UK to retain and broaden its preexisting regime of the OPE and in many instances to do away with or limit the use of equivalence determinations. 10.3 Separately, the FCA consulted on its treatment of third-country firms in the consultation paper CP20/20 and subsequently provided a Feedback Statement, FS21/3, setting out its approach to international firms providing (or seeking to provide) financial services that require UK authorisation. This has informed the FCA’s approach to overseas firms, which can be found at: www. fca.org.uk/publication/corporate/approach-to-international-firms.pdf [accessed 5 August 2021]. The statement was issued in anticipation of the FCA having to authorise several incoming branches of EEA firms which benefited from its transitional powers. The FCA will pay particular attention to whether the firm is fit and proper, the extent to which they are able to supervise the conduct of the firm’s UK business, the potential outcomes in an insolvency situation, the role and accountability of the firm’s senior management, and the supervisory cooperation with the firm’s home state regulator. Clearly the ability of a firm to meet these requirements through a branch will determine whether the firm will be able to establish a branch or instead would be required to set up a subsidiary to provide services in the UK. 10.4 The levels at which the requirement for standalone resources is set (whether the presence is a UK branch of the overseas firm or a UK subsidiary) depends on the level and type of harm the activity can give rise to in the UK. The 144

The UK’s approach to its perimeter 10.7 harm could come about through the disorderly winddown of the activities of the entity in the UK, which could be left outside the control of the UK authorities if the activities are undertaken through a branch. This is due to the fact that in an insolvency, a UK branch will usually be wound up together with its head office as part of the insolvency proceedings for the international firm in its home country, thereby limiting in some cases the effective recourse of its customers in the UK. Depending on the scale of the activity, different outcomes may be possible (including the imposition by the regulators of limitations in the range of activities). The three main risks, against which the potential for harm is assessed, are: (1) Retail harm: Protection for the UK office’s retail customers, through redress and supervisory oversight for example, could be less effective, especially if the international firm becomes insolvent or exits the UK. (2) Client asset harm: The UK rules that protect client money or custody assets safeguarded through the UK office and the home state insolvency regime which may become applicable if the international firm fails to be aligned. This misalignment could negatively impact the outcome for UK clients. (3) Wholesale harm: Shocks or risks that originate from the international firm’s overseas offices could, in some circumstances, be more difficult to detect or prevent and could be passed easily to its UK office, affecting the stability and integrity of the UK markets in which it operates or to which it is connected. 10.5 When considering the appropriateness of resources and suitability of the firm, the FCA will take into account the rules requiring firms to have effective governance structures and management oversight in place, with clearly defined individual senior management accountability. Aspects of the senior management accountability regime apply to international firms that have a UK branch. The FCA has also clarified that the authorisation of a firm applies to the entire firm including its overseas offices. This means that, for an international firm, the authorisation will apply to the legal entity incorporated outside the UK, including its UK branch and its overseas head office. Firms operating from branches will also often demonstrate a high degree of interconnectedness between their UK and international establishments. 10.6 If such a firm intends to provide some services that require authorisation to UK customers from overseas (ie anywhere other than a UK establishment), the FCA will need to ensure that it can effectively supervise services provided to UK customers in this way. The presence of the branch may give the regulator some comfort that they can supervise the activity. However, in truth it could be an obstacle in detecting that there is activity on the ground not supervised or controlled locally and potentially exposing the investor base to risk. The consideration is more pertinent to retail customer business, as retail customers may not have the benefit of the protection of the Financial Services Compensation Scheme if the activity is undertaken from overseas. 10.7 In a similar vein, the Bank of England Prudential Regulation Authority (PRA) also published for consultation a supervisory statement, International banks: The PRA’s approach to branch and subsidiary supervision, in January 2021. As with the FCA, the PRA takes into account the integration of the UK operations of the firm with those of its overseas operations in assessing the risks it poses to the objectives of the PRA. The retail nexus again drives the approach 145

10.8  The future of market structure in Europe with retail deposits over a certain threshold triggering the requirement for a subsidiary rather than a branch. 10.8 Although the requirement to have sufficient cooperation arrangements with the overseas supervisor and efficient resolution arrangements has always been there for the authorities, that requirement is underlined in this supervisory statement, in the aftermath of Brexit and the run-up to considering the fate of a number of EU firms with incoming branches. It is therefore significant in acting as a warning shot to the authorities where these firms are headquartered. In addition, where the firm’s governance is provided by individuals with roles outside the branch, the PRA will have to assess whether this provides effective governance. Other factors include whether the booking arrangements are transparent and effective. 10.9 In conclusion, the authorities in the UK have begun the process of refocusing their perspective with regard to global finance and its access to the UK. On the one hand, there is renewed momentum in allowing international wholesale services to be provided to and from the UK, removing frictiongenerating obstacles. On the other hand, the provision of retail services on the ground in the UK through a branch structure has come into sharper focus and it is likely that the stance of the authorities will become tougher, especially if they do not receive reciprocity in their approach from EU Member States. The additional angle to that approach is that the hardened stance can be used as a negotiating card in the ongoing discussion regarding the future relationship of the UK with the EU. This more circumspect approach to cooperation is in keeping with the approach the UK has kept in relation to the DTO (see below): a more hard hitting position related to incoming branches of EU firms, essentially warning the EU that unless there is an agreement on mutual recognition of venues, the collateral damage may impact eventually EU-headquartered firms.

THE UK FUTURE REGULATORY FRAMEWORK (FRF) 10.10 The UK also consulted on HM Treasury’s Financial Services Future Regulatory Framework Review: Phase II  Consultation (October 2020) (the FRF). The FRF is aiming to give regulators greater flexibility in rule making and to remove some of the cumbersome legislative processes inherited through the onshoring of EU legislation. Many of the technical rules applicable to markets in the EU are not made by the expert authorities but are legislated as primary legislation by the European Commission, the EU  Council and the European Parliament. The problem with this process is that politicians who may be unfamiliar with the detail of market structure strive to implement measures with a possible adverse knock-on impact. In addition, the process can be incredibly long for measures which require agility by the regulators and fast implementation, to compete with the fast-evolving market landscape. 10.11 The onshoring of EU legislation onto the UK statute book post-Brexit has resulted in huge swathes of legislative measures being represented as primary legislation, contrary to the architecture of FSMA which envisioned a lot more flexibility through Statutory Instruments and regulatory guidance. The UK hopes to revert to that older approach. It is probably more likely that the regulators will be given even greater power than before to make and amend rules and regulations without parliamentary intervention. The FRF sets out that approach but also seeks to identify the correct checks and balances that should 146

The MiFID II review in Europe: revisiting what has not worked well 10.13 exist in the framework to continue to have accountability, combined with high quality regulation. That flexibility will be critical to the main aim of the UK postBrexit, which is to attract liquidity and international business through innovation and flexibility.

THE MIFID II REVIEW IN EUROPE: REVISITING WHAT HAS NOT WORKED WELL 10.12 Like all significant pieces of EU legislation, MiFID II has embedded in it a requirement to be subjected to review within three years of its implementation. Consequently, the German presidency of the EU conducted a consultation on the impact of MiFID II. Key areas of concern for the wholesale market were costs and charges, best execution reporting and the shares trading obligation. Subsequently, the German Ministry of Finance published two position papers on proposed changes to MiFID II/MiFIR regarding investor protection and market structure. These position papers have started an important discussion amongst market participants, investors and trade associations, well ahead of the MiFID II refit.1 The German proposal focused on a two-track system: near-term amendments that are necessary for the smoother operation of the regulatory framework and some longer-term adjustments which required more time for gestation. 10.13 Amongst the near-term amendments needed, the position papers listed the following: • Shares trading obligation: The scope of the shares trading obligation was identified by the German authorities as overly broad, thereby leading to legal uncertainties and unintended consequences. As seen at 7.2 above, there are serious unintended consequences associated with the STO and often EU investors could be disadvantaged in their inability to access international pools of liquidity. The German authorities recommended that, on this basis, the STO should be recalibrated or repealed if necessary. At least Article 23 of MiFIR should be modified to focus its application on shares that are listed in the EU. Shares listed in third countries should become subject to the STO only in very limited and clearly defined cases. In addition, equivalence decisions should be principles-based focusing on an overall assessment of the requirements in third countries. • Deferred post-trade publication of non-equity instruments: Article 21 (3) and (4) of MiFIR grants to NCAs various options regarding deferred post-trade publication of non-equity instruments. As a result, the deferred post-trade publication regimes of non-equity instruments vary widely across the EU and lack consistency. The German authorities have therefore suggested that the NCA options in Article 21 of MiFIR should be harmonised so as to achieve greater consistency in deferred publication. • Double volume cap: This controversial measure introduced in MiFID II as a means of limiting the amount of dark liquidity going through MTFs 1 https://www.bundesfinanzministerium.de/Content/DE/Gesetzestexte/Gesetze_ Gesetzesvorhaben/Abteilungen/Abteilung_VII/19_Legislaturperiode/Position-paper-MiFIDand-MiFIR.pdf?__blob=publicationFile&v=3 [accessed 6 August 2021]. https://www.bundesfinanzministerium.de/Content/DE/Gesetzestexte/Gesetze_ Gesetzesvorhaben/Abteilungen/Abteilung_VII/19_Legislaturperiode/Position-paper-MiFIDand-PRIIPS.pdf?__blob=publicationFile&v=9 [accessed 6 August 2021].

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10.14  The future of market structure in Europe became cumbersome to administer and created dislocations of liquidity which did not benefit the market. As the German authorities observed, the DVC, as calibrated, leads to a shifting of trading volumes from orderbook trading towards auction-based trading, thereby calling into question the original purpose of the DVC mechanism to ensure price formation. Against this backdrop the DVC mechanism should be subject to a general re-assessment. At a minimum, the DVC thresholds should be reviewed on short notice. •

Costs and charges: Another largely problematic element of MiFID II was the need to provide eligible counterparties and professional clients with disclosures which were often meaningless. Fulfilling these requirements was burdensome for investment firms, while wholesale clients usually have different sources of information and the expertise to assess costs and charges without being dependent on information about every transaction. The German authorities suggested not their complete abolition, but the ability of professional clients and eligible counterparties to opt out from them.

10.14 In addition to these short term amendments, the German authorities suggested some longer term priorities which they wanted to pursue, amongst them: •

Market structure/systematic internalisers: Following the existing protectionist approach to primary venues and seeking to create obstacles to OTC liquidity which is often viewed by the European authorities as being in competition with venue liquidity, they sought an analysis of the market structure. The direction of travel was made clear when they stated that their objective was to ensure a level playing field between different types of trading venues and systemic internalisers. This echoed advocacy advanced by the exchanges in recent years in which they protested against the flexibility that systematic internalisers have as opposed to market operators. The German authorities suggested a need to re-calibrate certain core features such as tick sizes, standard market sizes and OTC  versus trading venue thresholds.

•

Application of ‘traded on a trading venue’ (ToTV) to OTC derivatives: Transparency and transaction reporting requirements apply to financial instruments that are ToTV. According to the German authorities, while the ToTV concept is applied successfully to fully standardised instruments, its application to non-standardised OTC derivatives remains doubtful because these instruments are deemed to be ToTV when they share the same reference data details as ETD even though they may include additional terms that significantly alter the instrument but are not contained in the reference data. The application of ToTV to such OTC derivatives should therefore be re-assessed.

•

Cost of market data: It is an old gripe of the industry in Europe that the cost of trading is much higher than in the US, largely due to the very high cost of market data. The German authorities honed in on this need to further consolidate data and to offer it at competitive prices. They recommended that the cost implications for access to and use of market data need to be analysed further with a view to (a) avoiding inappropriate pricing structures, and (b) giving data providers an incentive to develop services that are innovative and meet market demands. Furthermore, it should be assessed whether competition authorities rather than financial supervisory authorities would be better suited for ensuring that pricing

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Suspension of regulatory obligations inder Covid-19 in the EU 10.15

•

•

•

policies are set up on a ‘reasonable commercial basis’, hinting heavily that they suspect some monopoly practices at play. Consolidated tape providers (CTPs): In view of the fact that there are currently no CTPs for equities and non-equities in the EU, it would be useful to conduct a thorough assessment of the effects of a lack of CTPs and the potential benefits of and a need for (a) recognising or establishing a CTP for equities and possibly non-equities, or (b) modifying the regulatory requirements for CTPs. Such an assessment should include an in-depth cost/benefit analysis of possible regulatory action. Introduction of semi-professional clients: One of the suggestions that the industry has put forward in terms of client classification and the categories that were reviewed in Chapter  1 is that the plethora of protections afforded to retail clients are ill-suited to individuals who have similar sophistication to professional clients. MiFID does not differentiate between inexperienced retail clients, who need all of the information and protection provided for in MiFID, and experienced retail clients, who are very active in financial markets and therefore might not have the same need for information. The German authorities embraced the idea that a new category of semi-professional client could be contemplated. They have therefore suggested a review of how this could be defined properly and how information requirements could be limited in such a way that they apply only to inexperienced retail clients. Research: Again, in line with the debate that was traced in Chapter  5 regarding unbundling, the European authorities had been less convinced about the need for unbundling at the level that was achieved in MiFID II and after Brexit felt able to reverse some of that framework. The German authorities acknowledged the divided opinions of the industry with some market participants stating that these rules have had positive effects on research costs (especially for research relating to large companies), while others claim that these rules have had negative effects on SME research. In line with the objectives also of other major European nations regarding a boost of SME markets, the German authorities suggested a thorough review on the impact that these rules have had on the costs and availability of research relating to small and medium-sized businesses. Any amendments to the legislation should ensure that incentives for providing an adequate amount of research on SMEs are set.

SUSPENSION OF REGULATORY OBLIGATIONS UNDER COVID-19 IN THE EU: THE ‘MIFID QUICK FIX’ 10.15 Several of the German recommendations found their way into the package of measures approved by the EU in response to the Covid-19 crisis as a means of assisting recovery. This series of measures were included in a Directive snappily entitled ‘Directive (EU) 2021/338 of the European Parliament and of the Council of 16  February 2021 amending Directive 2014/65/EU as regards information requirements, product governance and position limits, and Directives 2013/36/EU and (EU) 2019/878 as regards their application to investment firms, to help the recovery from the COVID-19 crisis’, otherwise known as the ‘MiFID  Quick Fix’. The MiFID  Quick Fix came into force in March 2021 when it was published in the Official Journal, but, as a Directive, it includes a nine-month implementation period for national implementation in 149

10.16  The future of market structure in Europe the different Member States. Then there is a year-long implementation period for the industry which means that the measures will not be in effect before 28  November 2022, calling into question how quick the fix is. Superfluous regulatory obligations were set aside as a temporary measure for a period of two years from 28 November 2022. However, these temporary amendments are still of great significance as they are viewed as a precursor to the more permanent changes that will be introduced in the MiFIR and MiFID refit, resulting in the eventual MiFID III. In summary the temporary measures include: • Relaxation of the unbundling rules for SMEs, allowing a combination of research and execution charges in the same dealing commission, if the relevant research and execution concerns issuers whose market capitalisation for the period of 36 months preceding the provision of the research did not exceed €1 billion, as expressed by end-year quotes for the years when they are or were listed or by the own-capital for the financial years when they are or were not listed. • An abolition of the costs and charges disclosure for ECPs and opt-out option for professional clients; the ability to provide the costs and charges disclosure to retail clients electronically, unless they request paper communication. • A suspension of the need to produce RTS 27 best execution reports until 28 February 2023, as well as a long-term review of the need for RTS 27 and RTS 28 reports to be conducted by ESMA by 28 February 2022. • Significant adjustments to commodities position limits. 10.16 In a surprising move, the suspension of the best execution reporting obligation in respect of RTS  27 was brought forward by the European Commission in a direct intervention to the impacted NCAs and became effective from March 2021, significantly earlier than the MiFID  Quick Fix suggested. This meant that the reports published on 31 December 2020 were essentially the last reports published in the EU in respect of RTS 27. Although the reporting requirement has not been repealed fully, the unanimous view is that it contributes little, especially when one considers the cost of its production, so it should be anticipated that it will be abolished in the long run. By the time the data is published, it is between three and six months stale and therefore anyone seeking to inform their execution strategy by identifying significant liquidity providers would have already used other public sources to do so. 10.17 Similar arguments have been made by the buy-side in respect of RTS 28, which may also be revised or abolished. The information it entails does not necessarily provide a clear picture of the venues preferred by order placing entities (brokers and portfolio managers), as technical interpretation often means that the venues identified in the report are the affiliates of the regulated entity handling the orders.

THE UK QUICK FIX 10.18 Whilst the UK shared many of the concerns expressed by the EU in the MiFID  Quick Fix, the timetable for the EU of bringing into force the MiFID Quick Fix was to be completed after the end of the transition period and the UK was not to going be bound by it. Therefore, the UK opted to follow its own ‘Quick Fix’ after the end of the transition period and, having the flexibility to legislate and implement regulation faster outside the EU, set out its agenda in 150

The UK Quick Fix 10.21 March 2021 with similar initiatives. Much like the EU, the UK also wanted to suspend the production of RTS 27 best execution reports, suspend the need for costs and charges disclosures to ECPs and to reconsider the unbundling regime, especially in relation to SMEs, but also in respect of fixed income research. The proposal in respect of research in the UK was a departure from the traditional UK approach, considering it was the UK FCA that had been the main proponent of complete unbundling. 10.19 The UK brought about some of these changes through a new approach, which had previously been unfamiliar and not in keeping with the strict observance of the rule book. The FCA simply announced that it will not be taking any enforcement action against firms that are not producing RTS  27 reports while it is consulting on the future of such reports. A formal declaration of forbearance is an instrument which had rarely, if ever, been used by the FCA. 10.20 Subsequently, in CP21/9 (Changes to UK  MiFID’s conduct and organisational requirements) in April 2021, the FCA began a consultation to permanently remove from its rulebook the requirement for the RTS  27 reports and the RTS  28 reports. This initiative goes beyond the scope of the EU’s MiFID  Quick Fix and the UK’s own forbearance statement. It should be expected that such suspension will be welcomed by the industry and implemented. In the same consultation paper, the FCA is consulting on revisions to the unbundling regime. In line with the EU’s MiFID  Quick Fix ,the FCA is proposing a ‘rebundling’ of dealing commissions for research over SMEs, but has set the proposed threshold for entities qualifying as SMEs at £200m market capitalisation, as opposed to €1bn, which is the EU threshold. The UK proposal would therefore have a smaller impact. It also proposes a rebundling of fixed income research, including macro research, for portfolio managers who are active in fixed income strategies, accepting the longstanding argument of the industry that there had never been implicit payment for research in that sector in the past and that the unbundling regime was an artifice. 10.21 In addition, the FCA decided that the double volume cap (DVC) did not serve any purpose and, similar to the RTS 27 forbearance statement, it used regulatory communication to remove it. One of the most controversial initiatives in MiFID II was the introduction of the DVC on venues which benefit from two important pre-trade transparency waivers, the reference price waiver and the negotiated trade waiver. As seen earlier, the German authorities had already called into question the operation of the DVC and its usefulness in limiting dark liquidity in the EU. However, ESMA and the European Commission did not proceed to suspend the operation of the DVC in the EU as part of the MiFID  Quick Fix. The FCA stated at the end of the transition period that it would not renew the caps that had applied on UK shares traded on UK MTFs and then subsequently, in March 2021, decided to also let the caps lapse without renewal for all EU shares traded on UK MTFs. This is significant not just in the context of the MiFID review that the UK will be conducting longer-term itself, where we should expect to see no DVC, but also in the battle for liquidity following Brexit. By removing the DVC for EU shares, the FCA introduced additional flexibility for UK MTFs that their EU peers could not enjoy. This creates pressure for international participants who are not tied by the EU’s STO to choose instead UK venues that give them more flexibility. It is certainly an act of bringing the battle to the EU, although interestingly the FCA left the door of negotiation open, but stating that should there be a future mutual recognition with the EU, they would be willing to reconsider the FCA’s position. 151

10.22  The future of market structure in Europe 10.22 The carrot and stick approach vis-à-vis the EU in respect of the DVC was replicated by the FCA in respect of the DTO. Having haemorrhaged to Dutch venues the liquidity in EU shares that used to reside in UK MTFs upon the end of the transition period (see above, at para  7.23), the UK authorities were concerned that a similar trend could follow in respect of the DTO. There were already some early indications that some interest rate swaps had moved to EU venues. The FCA issued guidance that essentially warned UK branches of EU firms that they had to comply with the UK DTO rather than the EU DTO. To the extent that they faced EU dealers they had to seek to execute the trades subject to the DTO on EU SEFs. In respect of EU clients without access to EU SEFs they were allowed to execute the trade on UK trading venues. 10.23 This came in addition to the clearing war about the location of eurodenominated derivatives subject to the clearing obligation in EMIR. In terms of clearing, the UK dominates the global interest rate swaps market with the vast majority of these trades being cleared at LCH  Limited. The concentration of such liquidity in the UK, without a strong competitor emerging in the EU, gave rise to a significant bone of contention between the EU and the UK with the former threatening to not recognise LCH Limited as an eligible clearing house for EU counterparties for interest rate swaps subject to the clearing obligation. The ability of EU counterparties to bring trades onto these clearing venues has been critical to them and the EU had to agree to provide temporary equivalence determinations for these purposes. However, these short- to medium-term temporary recognitions are not sure-footed and create a constant threat of cliff edges, which the UK wanted to avoid. Considering that a longer term accommodation with equivalence across all key regulatory obligations had not been found, the UK changed approach and in 2021 began creating its own cliffedges in the relationship with the EU to enhance its negotiating position.

THE LONGER-TERM AGENDA BY THE UK 10.24 As the UK goes down its own path of regulatory flexibility, a new approach is emerging amongst the UK authorities which promotes pragmatism, the wish to listen to industry concerns and to attract international business, without diluting the key regulatory protections and high supervisory standards for which the jurisdiction has been known over the years. The new agenda that is emerging is focused on revisiting key market structure categories and retesting their boundaries. It is not clear that the UK will observe the somewhat artificial boundaries between regulated markets, multilateral trading facilities and systematic internalisers in equities. Similarly, the unclear and often artificial distinction between multilateral trading facilities and organised trading facilities may be collapsed into a single category. More importantly, within those trading systems, the obstacles to innovation imposed in respect of trading modality (tick size limitations, inability to cross at mid-point within an SI, DVC on pre-trade transparency waivers) would be limited or eliminated to allow for liquidity to flow naturally to the venues where investors achieve best outcomes.

A FUTURE OF REPEATED CLIFF EDGES AND REGULATORY COMPETITION 10.25 The climate that has developed in the region, following the end of the transition period, has become a landscape that fosters ongoing competition 152

A future of repeated cliff edges and regulatory competition 10.25 between the EU and the UK. This means that the attempt to achieve compromise in inter-regional recognition of regulatory obligations is constantly being traded off against the willingness to strike out on one’s own. In fact the two trends are bound to co-exist for a long time. One can imagine that the clearing recognition sought by the UK regularly could be traded off against certain market developments, but also that the UK would be deploying certain regulatory guidance in anticipation of cliff-edges, to ensure that it has certain negotiation cards in its relationship with the EU. It will be a long period of gradual divergence between the two jurisdictions, where every initiative will have a countermeasure attached to it and every attempt to attract liquidity may be met with a matching attempt from the other side. One thing is certain: the regulatory competition between the two jurisdictions will increase the power of the industry vis-à-vis regulators and will drive further flexibility and innovation. Several of the concepts discussed in this book, especially regarding market structure, will continue to evolve and to throw open new and interesting questions for the lawyers of the future.

153

Index

[all references are to paragraph number] Agency trading best execution, 9.10 dealing commissions, 5.3 Algorithmic trading best execution, 9.23–9.27 categories, 8.5 compliance with RTS 6, 8.8 definition, 8.4 generally, 8.2–8.9 MIFID II, 8.4 ‘intelligent function’, 8.4 investment algorithms, 8.5 notification to NCA, 8.8 requirements, 8.6–8.9 trading algorithms, 8.5 Ancillary services MiFID II, 2.60 Assessment of suitability conduct of business, 3.30 Authorisation ancillary services, 2.60 background, 2.1 Brexit ECB, and, 2.57–2.58 generally, 2.47–2.50 impact on regimes, 2.51–2.53 characteristic performance for services, 2.12–2.16 client categories, 2.62 co-existence of regimes, 2.33–2.35 determining if investment and service are regulated, 2.5–2.6 dual-track system co-existence, 2.33–2.35 harmonisation, 2.18–2.21 introduction, 2.17 Investment Firm Review, 2.31 ISD, 2.22 MiFID II, 2.23–2.28 provision of services, 2.23–2.28 reverse solicitation, 2.29–2.30 third country firms, 2.33–2.35 European Central Bank’s approach, 2.57–2.58

Authorisation – contd European single market, 2.18–2.21 FCA Rulebook ‘by way of business’, 2.38 Exemptions from authorisation, 2.41–2.42 generally, 2.37–2.42 ‘in the UK’, 2.39–2.40 introduction, 2.36 offences, 2.36–2.37 Overseas Person Exclusion, 2.43– 2.46 financial instruments, 2.61 fundamental freedoms, 2.18–2.19 harmonisation generally, 2.18–2.21 national interests, and, 2.54–2.56 high frequency trading, and, 8.21 Investment Firm Review, 2.31 investment services and activities, 2.59 Investment Services Directive 1993, 2.22 MiFID II ancillary services, 2.60 branch passports, 2.26 client categories, 2.62 financial instruments, 2.61 generally, 2.23–2.28 introduction, 2.19 Investment Firm Review, 2.31 investment services and activities, 2.59 passporting, 2.26 provision of services from one member state to another, 2.26 reverse solicitation, 2.29–2.30 third country provision of services, 2.24–2.28 national interests, and, 2.54–2.56 need determining if investment and service are regulated, 2.5–2.6 introduction, 2.4 performance for services, 2.12–2.16

155

Index Authorisation – contd need – contd provision of a service, 2.7–2.8 solicitation for service, 2.9–2.11 Overseas Person Exclusion, 2.43–2.46 performance for services, 2.12–2.16 Perimeter Guidance (PERG) ‘by way of business’, 2.38 Exemptions from authorisation, 2.41–2.42 generally, 2.37–2.42 ‘in the UK’, 2.39–2.40 introduction, 2.36 offences, 2.36–2.37 Overseas Person Exclusion, 2.43– 2.46 provision of services jurisdiction, and, 2.7–2.8 MiFID II, 2.23–2.28 public policy, 2.1–2.3 purpose, 2.3 request for the service, 2.9–2.11 reverse solicitation generally, 2.29–2.30 introduction, 2.11 service provided in the jurisdiction, 2.7 service provided into the jurisdiction characteristic performance, 2.12– 2.16 generally, 2.7 service provided out of jurisdiction, 2.7 single market, 2.18–2.21 solicitation generally, 2.9–2.10 reverse, 2.11 third country firms, 2.33–2.35 UK regulatory framework, 2.36–2.46 use, 2.3 Banking Consolidation Directive (BCD) single market, and, 2.19 Best execution agency trading, and, 9.10 algorithmic trading, and, 9.23–9.27 broker crossing networks, and, 9.28 CESR guidance, 9.13–9.18 challenges algorithmic trading, to, 9.23–9.27 OTC markets, in, 9.19–9.22 client reporting generally, 9.34–9.36 MiFID Quick Fix, 10.15–10.17 RTS 27, 9.37–9.41 RTS 28, 9.42–9.44 conduct of business, 3.31 dark trading monitoring, 9.28–9.32 definition, 9.4–9.5 electronic trading, and, 9.7

156

Best execution – contd eligible counterparties, and, 9.13 evolution of duty, 9.10–9.12 external liquidity providers, and, 9.28 FCA guidance, 9.13–9.18 ‘four-fold test’, 9.13 introduction, 9.1–9.3 liability for failure of duty, 9.45–9.47 ‘market practice’, 9.16 MiFID evolution of duty, 9.12 introduction, 9.3 programme monitoring, 9.33 reports to clients, 9.34 single venue monitoring, 9.28 ‘sufficient steps’, 9.4 monitoring programmes, 9.33 nature of duty, 9.6 OTC markets, in, 9.19–9.22 ‘primary dealers’, 9.16 programme monitoring, 9.33 ‘reasonable steps’, 9.4 reports to clients generally, 9.34–9.36 MiFID Quick Fix, 10.15–10.17 RTS 27, 9.37–9.41 RTS 28, 9.42–9.44 requirements, 9.5 ‘riskless principal capacity’, 9.10 scope of outcomes, 9.7–9.9 single venue monitoring, 9.28–9.32 smart order router, and, 9.25–9.27 ‘sufficient steps’ standard, 9.4–9.5 systematic internalisers, and, 9.28 transparency, 9.18 Bilateral trading demise of BCNs, 6.18 ESMA review, 6.49–6.50 generally, 6.7–6.10 pre-trade transparency, 6.22 trading obligations, and, 7.1–7.2 Brexit authorisation ECB, and, 2.57–2.58 generally, 2.47–2.50 impact on regimes, 2.51–2.53 derivatives trading obligation, 7.35– 7.39 future of market structure Covid-19 recovery measures, 10.15 FRF Review, 10.10–10.11 introduction, 10.1 longer-term agenda, 10.24 MiFID II review, 10.12–10.14 Quick Fix, 10.15–10.23 regulatory competition, 10.25 UK approach to perimeter, 10.2–10.9 introduction, 1.7

Index Brexit – contd shares trading obligation generally, 7.20–7.24 Switzerland, 7.19 Broker crossing networks (BCNs) best execution, 9.28 demise, 6.18–6.19 generally, 6.2–6.6 Brokerage services dealing commissions UK experience, 5.39 US approach, 5.24–5.27 Brokers’ obligations dealing commissions, 5.63–5.65 Bulletin boards trading systems, 6.50 Bundling dealing commissions, 5.7–5.8 Buyback programmes market abuse, 4.37 Capital introduction dealing commissions, 5.12 Capital Requirements Directive (CRD) single market, and, 2.19 Capital Requirements Regulation (CRR) single market, and, 2.19 Central Securities Depositary Regulations (CSDR) single market, and, 2.20 Characteristic performance authorisation, 2.12–2.16 Client asset harm future of market structure, 10.4 Client categories authorisation, 2.62 Client classification conduct of business, 3.27 Client communication conduct of business, 3.28 Client information market abuse, 4.22–4.24 Client reporting generally, 9.34–9.36 MiFID Quick Fix, 10.15–10.17 RTS 27, 9.37–9.41 RTS 28, 9.42–9.44 Code of Market Conduct market abuse, 4.2 Co-location high frequency trading, 8.14–8.15, 8.25 Commission sharing arrangements dealing commissions, 5.30–5.34 Commissions ‘agency’ trading, 5.3 brokerage services UK experience, 5.39 US approach, 5.24–5.27

Commissions – contd brokers’ obligations, 5.63–5.65 bundling, 5.7–5.8 capital introduction, 5.12 commission sharing arrangements, 5.30–5.34 Conduct of Business Sourcebook (COBS), 5.35 conflicts of interest generally, 5.7–5.14 US and EU regimes, between, 5.66–5.68 corporate access generally, 5.47 introduction, 5.12 meaning, 5.48 prohibition, 5.49–5.55 UK experience, 5.42 ‘Dear CEO’ letter, 5.44–5.46 delivery versus payment (DvP), 5.3 FSA regime, 5.35–5.43 introduction, 5.1–5.6 MiFID I, 5.43 MiFID II brokers’ obligations, 5.63–5.65 conflicts of interest, 5.66–5.68 determining initial price, 5.73–5.76 generally, 5.55–5.56 ‘in scope clients’, 5.70 ‘loss-leading’ items, 5.73 payment mechanism, 5.57–5.62 practical guide, 5.69–5.76 pricing principles, 5.70 subsequent issues, 5.77–5.79 portfolio churning European approach, 5.45 introduction, 5.8 practical guide determining initial price, 5.73–5.76 introduction, 5.69 pricing principles, 5.70 pricing determining initial price, 5.73–5.76 principles, 5.70 soft dollar ‘safe harbor’ advice, 5.20 agency, 5.28–5.29 analyses, 5.20 brokerage services, 5.24–5.27 common sharing arrangements, 5.30–5.34 ‘effecting’, 5.31 ‘eligible research services’, 5.20– 5.23 ‘expression of reasoning or knowledge’, 5.21 generally, 5.15–5.19 Guidance, 5.18

157

Index Commissions – contd soft dollar ‘safe harbor’ – contd influence on UK experience, 5.35– 5.43 ‘provided by’, 5.31 Release, 5.18–5.19 reports, 5.20 riskless principal transactions, 5.28–5.29 ‘spend’, 5.32 third party research, 5.30–5.34 strategies, 5.11 T+2, 5.3 third party research, 5.30–5.34 UK experience, 5.35–5.43 US approach, 5.15–5.34 Company protection market abuse, 4.1 Conduct of business best execution, 3.31 client classification, 3.27 communication with clients, 3.28 inducements, 3.32 introduction, 3.26 suitability assessment, 3.30 written agreements, 3.29 Conduct of Business Sourcebook (COBS) dealing commissions, 5.35 Conflicts of interest dealing commissions generally, 5.7–5.14 US and EU regimes, between, 5.66–5.68 market abuse, 4.4 primary obligations, 3.17–3.25 Contractual certainty primary obligations, 3.3 Corporate access dealing commissions generally, 5.47 introduction, 5.12 meaning, 5.48 prohibition, 5.49–5.55 UK experience, 5.42 Costs and charges MiFID II review, 10.13 MiFID Quick Fix, 10.15 Covid-19 future of market structure, 10.15 Dark trade monitoring best execution, 9.28–9.32 Dealing commissions ‘agency’ trading, 5.3 brokerage services UK experience, 5.39 US approach, 5.24–5.27 brokers’ obligations, 5.63–5.65

158

Dealing commissions – contd bundling, 5.7–5.8 capital introduction, 5.12 commission sharing arrangements, 5.30–5.34 Conduct of Business Sourcebook (COBS), 5.35 conflicts of interest generally, 5.7–5.14 US and EU regimes, between, 5.66–5.68 corporate access generally, 5.47 introduction, 5.12 meaning, 5.48 prohibition, 5.49–5.55 UK experience, 5.42 ‘Dear CEO’ letter, 5.44–5.46 delivery versus payment (DvP), 5.3 FSA regime, 5.35–5.43 introduction, 5.1–5.6 MiFID I, 5.43 MiFID II brokers’ obligations, 5.63–5.65 conflicts of interest, 5.66–5.68 determining initial price, 5.73–5.76 generally, 5.55–5.56 ‘in scope clients’, 5.70 ‘loss-leading’ items, 5.73 payment mechanism, 5.57–5.62 practical guide, 5.69–5.76 pricing principles, 5.70 subsequent issues, 5.77–5.79 portfolio churning European approach, 5.45 introduction, 5.8 practical guide determining initial price, 5.73–5.76 introduction, 5.69 pricing principles, 5.70 pricing determining initial price, 5.73–5.76 principles, 5.70 soft dollar ‘safe harbor’ advice, 5.20 agency, 5.28–5.29 analyses, 5.20 brokerage services, 5.24–5.27 common sharing arrangements, 5.30–5.34 ‘effecting’, 5.31 ‘eligible research services’, 5.20– 5.23 ‘expression of reasoning or knowledge’, 5.21 generally, 5.15–5.19 Guidance, 5.18 influence on UK experience, 5.35–5.43

Index Dealing commissions – contd soft dollar ‘safe harbor’ – contd ‘provided by’, 5.31 Release, 5.18–5.19 reports, 5.20 riskless principal transactions, 5.28–5.29 ‘spend’, 5.32 third party research, 5.30–5.34 strategies, 5.11 T+2, 5.3 third party research, 5.30–5.34 UK experience, 5.35–5.43 US approach, 5.15–5.34 Dealing in securities authorisation Brexit, 2.47–2.58 dual-track system, 2.17–2.35 MiFID II, 2.59–2.62 need, 2.4–2.16 public policy, 2.1–2.3 UK Perimeter Guidance, 2.36– 2.46 primary obligations Annex I of MiFID, 3.11–3.16 conduct of business, 3.26–3.32 conflicts of interest, 3.17–3.25 disclosure regimes, 3.39–3.48 interaction between firms and clients, 3.1–3.5 market transparency, 3.33–3.38 record keeping, 3.6–3.8 shareholding disclosures, 3.41–3.43 short selling, 3.44–3.48 trade booking, 3.8–3.10 transaction reporting, 3.39–3.40 ‘Dealing on own account’ high frequency trading, 8.21 trading systems, 6.7 ‘Dear CEO’ letter dealing commissions, 5.44–5.46 Delivery versus payment (DvP) dealing commissions, 5.3 Derivatives trading obligation (DTO) Brexit, and, 7.35–7.39 generally, 7.25–7.27 introduction, 7.1 origins, 7.2–7.5 procedure, 7.28–7.31 third-country venue equivalence, 7.32–7.34 UK Quick Fix, 10.22 Direct electronic access (DEA) generally, 8.27–8.32 introduction, 8.14 market access, 8.33–8.34 sponsored access, 8.35–8.36 types, 8.27

Direct market access (DMA) generally, 8.33–8.34 introduction, 8.27 Disclosure inside information, 4.10–4.21 shareholding disclosures, 3.41–3.43 short selling, 3.44–3.48 transaction reporting, 3.39–3.40 Discretion trading systems, 6.14–6.17 Double volume cap (DVC) MiFID II review, 10.13 transparency, 6.27 UK Quick Fix, 10.21–10.22 Electronic trading algorithmic trading categories, 8.5 compliance with RTS 6, 8.8 definition, 8.4 generally, 8.2–8.9 MIFID II, 8.4 ‘intelligent function’, 8.4 investment algorithms, 8.5 notification to NCA, 8.8 requirements, 8.6–8.9 trading algorithms, 8.5 best execution, 9.7 direct electronic access (DEA) generally, 8.27–8.32 introduction, 8.14 market access, 8.33–8.34 sponsored access, 8.35–8.36 types, 8.27 direct market access (DMA) generally, 8.33–8.34 introduction, 8.27 ESMA consultation, 8.46–8.51 high frequency trading (HFT) advantages, 8.17–8.20 authorisation, and, 8.21 co-location, 8.14–8.15, 8.25 dealing on own account, and, 8.21 definition, 8.13 direct electronic access, and, 8.14 disadvantages, 8.17–8.20 generally, 8.10–8.16 high message intraday rate, 8.16 latency mechanisms, 8.14 market making agreements, 8.22– 8.23 market making strategy, 8.23–8.24 MIFID II, 8.13 order to trade rations (OTRs), 8.26 price fluctuation, 8.19 proximity hosting, 8.14 requirements, 8.21–8.26 sponsored access, 8.14, 8.27

159

Index Electronic trading – contd ‘high touch’ trading, and, 8.1 introduction, 8.1 ‘kill switch’, 8.39 market access generally, 8.33–8.34 introduction, 8.27 risk control framework, 8.38–8.45 smart order router, 8.37 sponsored access generally, 8.35–8.36 introduction, 8.14 testing, 8.44–8.45 Eligible counterparties best execution, 9.13 ESMA electronic trading, 8.46–8.51 market abuse, 4.28–4.29 trading systems, 6.49–6.50 EU regulatory framework post-Brexit, and, 1.7 European Central Bank authorisation, 2.57–2.58 European single market authorisation, 2.18–2.21 Execution best, 3.31 generally, 3.3 simultaneous, 3.4 External liquidity providers best execution, 9.28 Financial Conduct Authority (FCA) authorisation ‘by way of business’, 2.38 Exemptions from authorisation, 2.41–2.42 generally, 2.37–2.42 ‘in the UK’, 2.39–2.40 introduction, 2.36 offences, 2.36–2.37 best execution, 9.13–9.18 corporate access, 5.49–5.54 future of market structure, 10.3–10.6 market manipulation, 4.27 pricing principles, 5.70 Financial instruments authorisation, 2.61 Financial Promotions Order future of market structure, 10.2 generally, 2.36 Financial Standards Authority (FSA) dealing commissions, 5.35–5.43 insider dealing, 4.13–4.19 FIX connections primary obligations, 3.5 Fundamental freedoms authorisation, 2.18–2.19

160

Future of market structure client asset harm, 10.4 Covid-19 recovery measures, 10.15 electronic trading, 8.46–8.51 FCA consultation, 10.3–10.6 Financial Promotions Order, 10.2 Future Regulatory Framework (FRF), 10.10–10.11 HM Treasury ‘Overseas Framework’ (2020), 10.2 introduction, 10.1 longer-term agenda, 10.24 MiFID Quick Fix, 10.15–10.17 MiFID II review, 10.12–10.14 overseas persons exclusion, 10.2 PRA consultation, 10.7–10.8 Quick Fix, 10.15–10.23 regulatory competition, 10.25 retail harm, 10.4 UK approach to perimeter, 10.2–10.9 UK Quick Fix, 10.18–10.23 wholesale harm, 10.4 Future Regulatory Framework (FRF) future of market structure, 10.10–10.11 Handling client information market abuse, 4.22–4.24 Harmonisation generally, 2.18–2.21 national interests, and, 2.54–2.56 Investment Firm Review, 2.31 High Frequency Trading (HFT) advantages, 8.17–8.20 authorisation, and, 8.21 co-location, 8.14–8.15, 8.25 dealing on own account, and, 8.21 definition, 8.13 direct electronic access, and, 8.14 disadvantages, 8.17–8.20 generally, 8.10–8.16 high message intraday rate, 8.16 latency mechanisms, 8.14 market making agreements, 8.22–8.23 market making strategy, 8.23–8.24 MIFID II, 8.13 order to trade rations (OTRs), 8.26 price fluctuation, 8.19 proximity hosting, 8.14 requirements, 8.21–8.26 sponsored access, 8.14, 8.27 trading systems, and, 6.3 High message intraday rate high frequency trading, 8.16 ‘High touch’ trading electronic trading, and, 8.1 HM Treasury ‘Overseas Framework’ (2020) future of market structure, 10.2

Index Indications of interest primary obligations, 3.2 Inducements conduct of business, 3.32 Information parity market abuse, 4.1 Insider dealing characteristics, 4.11 differing approaches, 4.14 elements, 4.12 example, 4.13–4.21 generally, 4.10 handling client information, 4.22–4.24 pre-hedging, 4.23 segregation of desks, 4.23 Inside information generally, 4.10–4.21 proposed revisions, 4.38 Insider list market abuse, 4.34 Insurance Distribution Directive (IDD) single market, and, 2.19 Integrity market abuse, 4.4–4.5 ‘Intelligent function’ algorithmic trading, 8.4 Interconnected Sis systemic internaliser regime, 6.44–6.46 Internal crossing systems trading systems, 6.50 Investment advice suitability assessment, 3.30 Investment services and activities authorisation, 2.59 Investment Services Directive (ISD) 1993 generally, 2.22 introduction, 2.19 Investor protection market abuse, 4.1 Issuer buyback programmes market abuse, 4.37 ‘Kill switch’ electronic trading, and, 8.39 Large-in-scale transactions trading system transparency, 6.24 Layering market abuse, 4.29 LIBOR rate fixing market abuse, 4.3 Mandatory trading obligations derivatives trading obligations Brexit, and, 7.35–7.39 generally, 7.25–7.27 procedure, 7.28–7.31

Mandatory trading obligations – contd derivatives trading obligations – contd third-country venue equivalence, 7.32–7.34 introduction, 7.1 origins, 7.2–7.5 shares trading obligations (STO) Brexit, and, 7.20–7.24 exceptional circumstances, 7.12– 7.15 generally, 7.6–7.11 political weapon, as, 7.16–7.19 retained EU law, and, 7.20 Swiss experience, 7.16–7.19 third-country venue equivalence, 7.12–7.15 Market abuse buyback programmes, 4.37 client information, 4.22–4.24 Code of Market Conduct, 4.2 company protection, 4.1 conflicts of interest, 4.4 disclosure of inside information, 4.10–4.21 ESMA electronic trading, 4.28–4.29 handling client information, 4.22–4.24 information parity, 4.1 insider dealing characteristics, 4.11 differing approaches, 4.14 elements, 4.12 example, 4.13–4.21 generally, 4.10 handling client information, 4.22– 4.24 pre-hedging, 4.23 segregation of desks, 4.23 inside information generally, 4.10–4.21 proposed revisions, 4.38 insider list, 4.34 integrity, 4.4–4.5 investor protection, 4.1 issuer buyback programmes, 4.37 layering, 4.29 LIBOR rate fixing, 4.3 Market Abuse Directive, 4.8 Market Abuse Regulation extraterritorial nature, 4.9 generally, 4.8 handling client information, 4.22– 4.24 insider dealing, 4.10–4.21 inside information, 4.10–4.21 insider list, 4.34 introduction, 4.2 market manipulation, 4.25–4.32 market soundings, 4.33–4.35

161

Index Market abuse – contd Market Abuse Regulation – contd pre-hedging, 4.39 proposed revisions, 4.36–4.40 reporting obligations, 4.37 scope, 4.9 territorial nature, 4.9 violations, 4.9 market manipulation generally, 4.25–4.30 introduction, 4.6 stabilisation, 4.31–4.32 market soundings generally, 4.33–4.35 reporting obligations, 4.40 MiFID, 4.9 momentum ignition, 4.29 objectives of regime, 4.1–4.3 ping orders, 4.29 predatory practices, 4.1 pre-hedging generally, 4.23 reporting obligations, 4.39 prohibition against insider dealing characteristics, 4.11 differing approaches, 4.14 elements, 4.12 example, 4.13–4.21 generally, 4.10 handling client information, 4.22– 4.24 pre-hedging, 4.23 segregation of desks, 4.23 purpose, 4.1 quote stuffing, 4.29 reporting obligations, 4.37 sales, 4.4–4.7 segregation of desks, 4.23 ‘special knowledge’, 4.1 spoofing, 4.29 trading, 4.4–4.7 unlawful disclosure of inside information, 4.10–4.21 Market Abuse Directive (MAD) 2014 generally, 4.8 single market, and, 2.20 Market Abuse Regulation (MAR) 2014 extraterritorial nature, 4.9 generally, 4.8 handling client information, 4.22–4.24 insider dealing, 4.10–4.21 inside information, 4.10–4.21 insider list, 4.34 introduction, 4.2 market manipulation, 4.25–4.32 market soundings, 4.33–4.35 pre-hedging, 4.39 proposed revisions, 4.36–4.40

162

Market Abuse Regulation (MAR) 2014 – contd reporting obligations, 4.37 scope, 4.9 single market, and, 2.20 territorial nature, 4.9 violations, 4.9 Market access electronic trading generally, 8.33–8.34 introduction, 8.27 Market data MiFID II review, 10.14 Market making agreements high frequency trading, 8.22–8.23 Market making strategy high frequency trading, 8.23–8.24 Market manipulation generally, 4.25–4.30 introduction, 4.6 stabilisation, 4.31–4.32 Market practice best execution, 9.16 Market soundings generally, 4.33–4.35 reporting obligations, 4.40 Market transparency introduction, 3.33–3.34 post-trade, 3.37–3.38 pre-trade, 3.35–3.36 Matched principal trading trading systems, 6.50 MiFID I dealing commissions, 5.43 shares trading obligations, 7.3 trading systems, 6.9 MiFID II algorithmic trading, 8.4 ancillary services, 2.60 best execution evolution of duty, 9.12 introduction, 9.3 programme monitoring, 9.33 reports to clients, 9.34 single venue monitoring, 9.28 ‘sufficient steps’, 9.4 branch passports, 2.26 client categories, 2.62 conflicts of interest, 3.23 dealing commissions brokers’ obligations, 5.63–5.65 conflicts of interest, 5.66–5.68 determining initial price, 5.73–5.76 generally, 5.55–5.56 ‘in scope clients’, 5.70 ‘loss-leading’ items, 5.73 payment mechanism, 5.57–5.62 practical guide, 5.69–5.76

Index MiFID II – contd dealing commissions – contd pricing principles, 5.70 subsequent issues, 5.77–5.79 derivatives trading obligation, 7.25 electronic trading algorithmic trading, 8.4 high frequency trading, 8.13 financial instruments, 2.61 future of market structure Quick Fix, 10.15–10.17 review, 10.12–10.14 generally, 2.23 high frequency trading, 8.13 introduction, 2.19 Investment Firm Review, 2.31 investment services and activities, 2.59 market abuse, 4.9 passporting, 2.26 primary obligations Annex I, 3.11–3.16 conflicts of interest, 3.23 mapping table, 3.16 record keeping, 3.6 provision of services from one member state to another, 2.2 Quick Fix, 10.15–10.17 record keeping, 3.6 reverse solicitation, 2.29–2.3 review, 10.12–10.14 shares trading obligation Brexit, and, 7.20 origins, 7.3 political weapon, as, 7.16–7.17 third country provision of services generally, 2.23–2.25 passporting, 2.26 regime, 2.27–2.28 trading systems broker crossing networks, 6.5 constraints on operators, 6.43 constraints on SI regime, 6.44–6.48 ‘dealing on own account’, 6.7 demise of BCNs, 6.18–6.19 discretion, 6.17 ESMA review, 6.49 multilateral trading facilities, 6.11– 6.13 over the counter trading, 6.9 pre-trade transparency, 6.20–6.27 systemic internaliser, 6.10 transparency in SI regime, 6.33 MiFID III generally, 10.15 MiFIR derivatives trading obligation generally, 7.25–7.26 procedure, 7.28

MiFIR – contd derivatives trading obligation – contd third-country venue equivalence, 7.32 single market, 2.19 shares trading obligation, 7.6–7.7 trading systems constraints on operators, 6.41 constraints on SI regime, 6.48 demise of BCNs, 6.18 discretion, 6.16–6.17 multilateral trading facilities, 6.13 tick sizes, 6.48 transparency in SI regime, 6.32, 6.36–6.39 Momentum ignition market abuse, 4.29 Multilateral trading facilities (MTFs) constraints on operators, 6.40–6.43 derivatives trading obligation, and, 7.25 ESMA review, 6.49–6.50 generally, 6.11–6.13 trading obligations, and, 7.4 National interests authorisation, and, 2.54–2.56 Natural liquidity trading systems, 6.2 Negotiated trade systems trading system transparency, 6.24 Order management system trading system transparency, 6.25 Order to trade rations (OTRs) high frequency trading, 8.26 Orders execution, 3.3–3.4 generally, 3.2–3.3 receipt, 3.5 Organised trading facilities (OTF) constraints on operators, 6.40–6.43 demise of BCNs, 6.18–6.19 derivatives trading obligation, and, 7.25 discretion, 6.15, 6.17 ESMA review, 6.49–6.50 introduction, 6.13 systematic internaliser, as, 6.9 Over the counter (OTC) trading best execution, 9.19–9.22 demise of BCNs, 6.18 ESMA review, 6.49–6.50 generally, 6.7–6.10 MiFID II review, 10.14 pre-trade transparency, 6.22 trading obligations, and, 7.1–7.5 Overseas person exclusion future of market structure, 10.2 generally, 2.43–2.46 single market approach, 2.34

163

Index Passporting authorisation, 2.26 Perimeter Guidance (PERG) ‘by way of business’, 2.38 exemptions from authorisation, 2.41–2.42 generally, 2.37–2.42 ‘in the UK’, 2.39–2.40 introduction, 2.36 offences, 2.36–2.37 Overseas Person Exclusion, 2.43–2.46 Ping orders market abuse, 4.29 Portfolio churning dealing commissions European approach, 5.45 introduction, 5.8 Predatory practices market abuse, 4.1 Pre-hedging generally, 4.23 reporting obligations, 4.39 Pre-trade transparency double volume cap, 6.27 generally, 6.20–6.23 introduction, 3.35–3.36 large-in-scale transactions, 6.24 negotiated trade systems, 6.24 order management system, 6.25 price discovery, 6.26 reference price systems, 6.24 shares trading obligations, 7.11 SI regime, in, 6.28–6.39 standard market size, 6.28 waivers, 6.24–6.27 Price discovery trading system transparency, 6.26 Price fluctuation high frequency trading, 8.19 Pricing dealing commissions determining initial price, 5.73–5.76 principles, 5.70 Primary dealers best execution, 9.16 Primary obligations Annex I of MiFID, 3.11–3.16 assessment of suitability, 3.30 best execution, 3.31 client classification, 3.27 client communication, 3.28 conduct of business best execution, 3.31 client classification, 3.27 communication with clients, 3.28 inducements, 3.32 introduction, 3.26 suitability assessment, 3.30 written agreements, 3.29

164

Primary obligations – contd conflicts of interest, 3.17–3.25 contractual certainty, 3.3 disclosure regimes shareholding disclosures, 3.41–3.43 short selling, 3.44–3.48 transaction reporting, 3.39–3.40 execution best, 3.31 generally, 3.3 simultaneous, 3.4 FIX connections, 3.5 indications of interest, 3.2 inducements, 3.32 interaction between firms and clients, 3.1–3.5 investment advice suitability assessment, 3.30 market transparency introduction, 3.33–3.34 post-trade, 3.37–3.38 pre-trade, 3.35–3.36 MiFID Annex I, 3.11–3.16 conflicts of interest, 3.23 mapping table, 3.16 record keeping, 3.6 orders execution, 3.3–3.4 generally, 3.2–3.3 receipt, 3.5 post-trade transparency, 3.37–3.38 pre-trade transparency, 3.35–3.36 provision of written agreements, 3.29 public disclosure regimes shareholding disclosures, 3.41–3.43 short selling, 3.44–3.48 transaction reporting, 3.39–3.40 record keeping, 3.6–3.8 request for a quote, 3.4 shareholding disclosures, 3.41–3.43 short selling, 3.44–3.48 simultaneous execution, 3.4 suitability assessment, 3.30 trade booking, 3.8–3.10 ‘traded ahead’, 3.8 transaction reporting, 3.39–3.40 transparency introduction, 3.33–3.34 post-trade, 3.37–3.38 pre-trade, 3.35–3.36 written agreements, 3.29 Post-trade transparency primary obligations, 3.37–3.38 Pre-trade transparency primary obligations, 3.35–3.36 Prohibition against insider dealing characteristics, 4.11

Index Prohibition against insider dealing – contd differing approaches, 4.14 elements, 4.12 example, 4.13–4.21 generally, 4.10 handling client information, 4.22–4.24 pre-hedging, 4.23 segregation of desks, 4.23 Provision of services authorisation jurisdiction, and, 2.7–2.8 MiFID II, 2.23–2.28 Provision of written agreements primary obligations, 3.29 Proximity hosting high frequency trading, 8.14 Prudential Regulation Authority (PRA) future of market structure, 10.7–10.8 Public policy authorisation, 2.1–2.3 Quick Fix MiFID, 10.15–10.17 UK, 10.18–10.23 Quote stuffing market abuse, 4.29 Reasonable steps best execution, 9.4 Record keeping primary obligations, 3.6–3.8 Reference price systems trading system transparency, 6.24 Regulated markets trading systems, 6.11–6.13 Reliable reference price trading systems, 6.24 Reporting best execution generally, 9.34–9.36 MiFID Quick Fix, 10.15–10.17 RTS 27, 9.37–9.41 RTS 28, 9.42–9.44 market abuse, 4.37 Request for a quote (RFQ) primary obligations, 3.4 Research MiFID II review, 10.14 Retail harm future of market structure, 10.4 Retained EU law shares trading obligations, 7.20 Reverse solicitation generally, 2.29–2.30 introduction, 2.11 Risk control electronic trading, 8.38–8.45

‘Riskless principal capacity’ best execution, 9.10 RTS 27 reports generally, 9.37–9.41 introduction, 9.34–9.36 MiFID Quick Fix, 10.15–10.16 RTS 28 reports generally, 9.42–9.44 introduction, 9.34–9.36 MiFID Quick Fix, 10.15–10.17 Sales market abuse, 4.4–4.7 Securities dealing authorisation Brexit, 2.47–2.58 dual-track system, 2.17–2.35 MiFID II, 2.59–2.62 need, 2.4–2.16 public policy, 2.1–2.3 UK Perimeter Guidance, 2.36–2.46 primary obligations Annex I of MiFID, 3.11–3.16 conduct of business, 3.26–3.32 conflicts of interest, 3.17–3.25 disclosure regimes, 3.39–3.48 interaction between firms and clients, 3.1–3.5 market transparency, 3.33–3.38 record keeping, 3.6–3.8 shareholding disclosures, 3.41–3.43 short selling, 3.44–3.48 trade booking, 3.8–3.10 transaction reporting, 3.39–3.40 Segregation of desks market abuse, 4.23 Service provided in the jurisdiction authorisation, 2.7 Service provided into the jurisdiction characteristic performance, 2.12–2.16 generally, 2.7 Service provided out of jurisdiction authorisation, 2.7 Shareholding disclosures primary obligations, 3.41–3.43 Shares trading obligations (STO) Brexit, and generally, 7.20–7.24 Switzerland, 7.19 conditions, 7.9 exceptional circumstances generally, 7.12–7.15 introduction, 7.9 generally, 7.6–7.11 introduction, 7.1 MiFID II review, 10.13 origins, 7.2–7.5 political weapon, as, 7.16–7.19

165

Index Shares trading obligations (STO) – contd pre-trade transparency, and, 7.11 retained EU law, and, 7.20 Swiss experience, 7.16–7.19 third-country venue equivalence, 7.12–7.15 transparency, and, 7.11 ‘undertakes’, 7.7 Short selling primary obligations, 3.44–3.48 Short Selling Regulation (SSR) single market, and, 2.20 Simultaneous execution primary obligations, 3.4 Single market authorisation, 2.18–2.21 Single venue monitoring best execution, 9.28–9.32 Smart order router best execution, 9.25–9.27 electronic trading, 8.37 Soft dollar ‘safe harbor’ See also Dealing commissions advice, 5.20 agency, 5.28–5.29 analyses, 5.20 brokerage services, 5.24–5.27 common sharing arrangements, 5.30– 5.34 ‘effecting’, 5.31 ‘eligible research services’, 5.20–5.23 ‘expression of reasoning or knowledge’, 5.21 generally, 5.15–5.19 Guidance, 5.18 influence on UK experience, 5.35– 5.43 ‘provided by’, 5.31 Release, 5.18–5.19 reports, 5.20 riskless principal transactions, 5.28– 5.29 ‘spend’, 5.32 third party research, 5.30–5.34 Solicitation generally, 2.9–2.10 reverse, 2.11 Solvency Directive single market, and, 2.19 ‘Special knowledge’ market abuse, 4.1 Sponsored access electronic trading generally, 8.35–8.36 introduction, 8.14 high frequency trading, 8.14, 8.27 Spoofing market abuse, 4.29

166

Standard market size trading system transparency, 6.28 Sufficient steps best execution, 9.4–9.5 Suitability assessment conduct of business, 3.30 Systemic internaliser (SI) regime best execution, 9.28 constraints, 6.44–6.48 generally, 6.7–6.10 interconnected Sis, 6.44–6.46 MiFID II review, 10.14 pre-trade transparency, 6.28–6.39 tick sizes, 6.47–6.48 trading obligations, and, 7.4 T+2 dealing commissions, 5.3 Third country firms authorisation, 2.33–2.35 Third-country venue equivalence derivatives trading obligation, 7.32– 7.34 shares trading obligation, 7.12–7.15 Third party research dealing commissions, 5.30–5.34 Tick sizes systemic internaliser regime, 6.47–6.48 Trade booking primary obligations, 3.8–3.10 Trade on a trading venue (TOTV) MiFID II review, 10.14 pre-trade transparency, 6.20 share trading obligation, 7.11 ‘Traded ahead’ primary obligations, 3.8 Trading market abuse, 4.4–4.7 Trading obligations derivatives trading obligations Brexit, and, 7.35–7.39 generally, 7.25–7.27 procedure, 7.28–7.31 third-country venue equivalence, 7.32–7.34 introduction, 7.1 MiFID II review, 10.13 origins, 7.2–7.5 shares trading obligations Brexit, and, 7.20–7.24 exceptional circumstances, 7.12– 7.15 generally, 7.6–7.11 political weapon, as, 7.16–7.19 retained EU law, and, 7.20 Swiss experience, 7.16–7.19 third-country venue equivalence, 7.12–7.15

Index Trading systems bilateral trading ESMA review, 6.49–6.50 generally, 6.7–6.10 broker crossing networks (BCNs) demise, 6.18–6.19 generally, 6.2–6.6 bulletin boards, 6.50 constraints MFT operators, on, 6.40–6.43 SIs, on, 6.44–6. ‘dealing on own account’, 6.7 derivatives trading obligations Brexit, and, 7.35–7.39 generally, 7.25–7.27 introduction, 7.1 origins, 7.2–7.5 procedure, 7.28–7.31 third-country venue equivalence, 7.32–7.34 discretion, 6.14–6.17 electronic trading algorithmic trading, 8.2–8.9 direct electronic access, 8.27–8.36 future proposals, 8.46–8.51 high frequency trading, 8.10–8.26 introduction, 8.1 risk control framework, 8.38–8.45 smart order router, 8.37 ESMA review, 6.49–6.50 High Frequency Trading (HFT), 6.3 Internal crossing systems, 6.50 introduction, 6.1 mandatory trading obligations derivatives, 7.25–7.39 introduction, 7.1 origins, 7.2–7.5 shares, 7.6–7.24 matched principal trading, 6.50 MiFID I, 6.9 MiFID II broker crossing networks, 6.5 constraints on operators, 6.43 constraints on SI regime, 6.44–6.48 ‘dealing on own account’, 6.7 demise of BCNs, 6.18–6.19 discretion, 6.17 ESMA review, 6.49 multilateral trading facilities, 6.11– 6.13 over the counter trading, 6.9 pre-trade transparency, 6.20–6.27 systemic internaliser, 6.10 transparency in SI regime, 6.33 multilateral trading facilities (MFTs) constraints on operators, 6.40–6.43 ESMA review, 6.49–6.50 generally, 6.11–6.13

Trading systems – contd natural liquidity, 6.2 organised trading facilities (OTF) constraints on operators, 6.40–6.43 demise of BCNs, 6.18–6.19 discretion, 6.15, 6.17 ESMA review, 6.49–6.50 introduction, 6.13 systematic internaliser, as, 6.9 over the counter (OTC) trading demise of BCNs, 6.18 generally, 6.8–6.9 pre-trade transparency, 6.22 pre-trade transparency double volume cap, 6.27 generally, 6.20–6.23 large-in-scale transactions, 6.24 negotiated trade systems, 6.24 order management system, 6.25 price discovery, 6.26 reference price systems, 6.24 SI regime, in, 6.28–6.39 standard market size, 6.28 waivers, 6.24–6.27 regulated markets, 6.11–6.13 reliable reference price, 6.24 shares trading obligations (STO) Brexit, and, 7.20–7.24 exceptional circumstances, 7.12– 7.15 introduction, 7.1 nature, 7.6–7.11 origins, 7.2–7.5 political weapon, as, 7.16–7.19 retained EU law, and, 7.20 Swiss experience, 7.16–7.19 third-country venue equivalence, 7.12–7.15 systemic internaliser (SI) regime constraints, 6.44–6.48 generally, 6.7–6.10 interconnected Sis, 6.44–6.46 pre-trade transparency, 6.28–6.39 tick sizes, 6.47–6.48 trading obligations derivatives, 7.25–7.39 introduction, 7.1 origins, 7.2–7.5 shares, 7.6–7.24 transparency, 6.20–6.23 Transaction reporting best execution generally, 9.34–9.36 RTS 27, 9.37–9.41 RTS 28, 9.42–9.44 primary obligations, 3.39–3.40 Transparency best execution 9.18

167

Index Transparency – contd introduction, 3.33–3.34 post-trade, 3.37–3.38 pre-trade, 3.35–3.36 shares trading obligations, 7.11 trading systems, 6.20–6.23 UK Quick Fix future of market structure, 10.18–10.23 UK regulatory framework authorisation, 2.36–2.46

168

Unbundling rules MiFID Quick Fix, 10.15 Unlawful disclosure inside information, 4.10–4.21 Waivers trading system transparency, 6.24–6.27 Wholesale harm future of market structure, 10.4 Written agreements conduct of business, 3.29