Límites de la revisión de la documentación

Besides internalisation, another form of ‘preferencing’ activity has been historically offered by brokers, and known as ‘internal crossing’. Part of the liquidity in the market – even for liquid equity markets – has always followed a different way of execution, generally called ‘upstairs trading’ (Madhavan, 2000). Those services provided on a discretionary basis have been evolving with time and are currently offered through sophisticated internal crossing engines. These engines utilise complex algorithms to achieve best execution, by either matching internally or executing on MiFID official venues (RMs and MTFs). These internal crossing systems are also more commonly defined as broker-dealer crossing systems (BCSs, or broker-dealer crossing networks BCNs if several BCSs interact in one or more pools of liquidity). In addition, ‘crossing’ activities are also subject to fiduciary duties and conduct of business rules (Arts. 19, 20, 21, MiFID; OTC) as well as arrangements to disclose conflicts of interests. While post-trade transparency obligations apply to them, they are not affected by pre-trade transparency or organisational requirements (CESR, 2010b).

MiFID captures internal matching activities offered by brokers/dealers through the definition of ‘transactions carried out on an OTC basis’. Three conditions should be met for trades to fall under the definition of OTC equity trade (Recital 53, MiFID):

i) Transactions must be ad hoc and irregular;

ii) Dealings take place with a wholesale counterparty; and iii) Dealings must be above the standard market size (SMS).

The interpretation around the implementation of these conditions is currently different across the industry. Market views consistently diverge around the business nature of BCNs, which for some perform the same business as RMs and MTFs and therefore should be classified as such.

One side of the market believes that there is part of OTC trading that should be traded on RMs/MTFs and SIs and are therefore subject to strict pre- trade transparency requirements and more effective post-trade reporting, while they acknowledge the importance of OTC trading in the MiFID text. Most will agree that all trading happening in Europe, including the one taking place under the OTC label, should be properly classified in order to preserve market quality and prevent any significant part of the market from escaping pre-trade transparency without any economic justification (see below) and other MTFs rules on access, discretion and surveillance. This part of the market argues that OTC performs the same function as RMs and MTFs, and if not properly classified, could increase liquidity fragmentation and weaken investor protection.

Moving from the assumption that the OTC trade reports used were meaningful and mostly accurate, a recent study tries to shed more light on OTC trading (Gomber & Pierron, 2010). Using current data on OTC trades, the authors show that about 39% of OTC trades are below retail size, 48% are below standard market size, 87% are below large-in-scale and 73% are too small to have a market impact according to their proprietary methodology. According to them, this should be enough to clarify that these networks deal with trades below the standard market size, even though orders are partially sent to regulated markets and MTFs. In addition, crossing systems are designed as ‘multilateral’ trading mechanisms that match trades, acting as ‘riskless counterparties’. Hence, 87% of trades could potentially escape the size-related pre-trade transparency waiver imposed on RM and MTF trades (Gomber & Pierron, 2010). These findings imply that the MiFID conditions to be considered ‘OTC trading’ are not met and therefore there should be a proper classification for these trades under current MiFID-official trading venues (see below).

Figure 21. Transparency obligations for venues under MiFID

Source: Gomber & Pierron (2010, p. 11).

This first position concludes that, even if OTC trades would be considered bilateral, 52% of them seem to be escaping MiFID rules of pre- trade transparency for SIs. In any case, they see BCSs as multilateral trading systems, that are systems managed by firms not operating on own account or taking any risk in the transaction (recital 44, MiFID). As a result multilateral trading systems should be classified as RMs and MTFs.

A countering view contests the abovementioned interpretation of recital 53. In their view, broker-dealer crossing systems (BCSs) are fully compliant with MiFID, which recognised their role in financial markets. However, those platforms should be better classified in the new MiFID text.

According to this second position (see graph below), the advanced brokerage services offered to clients (wholesale counterparties) through the use of BCNs meet the MiFID conditions for trades ‘carried out on an OTC basis’, since they are:

• Dealings with wholesale counterparties (e.g. asset management companies);

• Dealings (‘parent’ orders) above the standard market size; and • Dealings irregularly transacted with brokers/dealers.

Figure 22. Broker-dealer crossing system Clients (AM, etc) Broker/Dealer Front Desk Split and Diced (algorithmic trading) Parent Orders Child Orders Internal Crossing System Open Markets

Lit Markets Dark Markets

External Crossing Systems

BCN Broker/Dealer

External liquidity pools

Source: Authors.

They note that trades may be below the standard market size only after the broker/dealer has accepted to execute the trade and split the ‘parent’ order into ‘child’ orders, eventually routing them to several trading venues to minimise market impact (including internal crossing systems, as BCSs or BCNs, but also RMs and MTFs). They argue that the Directive refers to ‘parent’ orders since fiduciary duties and business conduct rules apply to the ‘parent’ order as a whole and not separately to each ‘child’ order. Nevertheless, in their view, most trades are sent to regulated markets and MTFs for execution, while usually less than 1/3 is ‘internally’ crossed. They argue that advanced brokerage services need to interact with internal crossing systems, which allow a smoother handling and execution of big orders. The general rationale for trading OTC is best execution of trades outside official markets. Moreover – besides the exemption of recital 53 – this position also argues that BCSs cannot be considered ‘multilateral’ since they do not act as ‘riskless counterparties’ since the ‘riskless’ position is part of the execution they carry on behalf of their clients. Since MiFID obliges them to provide best execution and apply other conduct of business arrangements, they should not be considered acting as ‘riskless counterparties’. In addition, recital 44 says that RMs and MTFs should be managed with non-discretionary rules, which is not the case for BCSs. Most of all, they claim that internalisation is

gradually becoming an indispensable complementary execution service to those offered by official markets, rather than a competing service as originally feared.

Finally, some players claim that imposing a trading threshold may represent a threat for the provision of complex and tailored brokerage services, as it needs to be accurately and constantly updated. Clarifications of the defining criteria of ‘OTC trades’ under MiFID and availability of data for full assessment and enforcement of best execution, and other conduct of business rules are needed. Once these aspects are defined, the burdens of the obligations would set a ‘natural’ threshold to the development of these trading systems with no threat to price formation processes in the open markets, since it would become highly costly to carry them out on a broad scale.

The European Commission (2010b, p. 11) has proposed a ‘new sub- regime for BCSs, which will de facto assign a new classification to these venues under MiFID organised trading facilities (see next box). This classification will work by setting two boundaries: i) if third parties will enter orders in the crossing system, the BCS would transform the system in an MTF; ii) if the broker/dealer executes internally against its own capital, the system would change in a SI.

Commission’s proposal

Figure 23. Proposal for broker dealer crossing system (BCSs) Broker-dealer crossing systems Multilateral trading facility Systematic internaliser - Matching against own capital become

- Third parties enter orders in the system Source: European Commission (2010b).

This proposal tries to accommodate conflicting views and it may represent a radical change for the definition of SI and MTF. For instance, if third parties enter orders in the system, it does not necessarily mean that the system is based on non-discretionary rules (such as an MTF). Therefore, this proposal will de facto modify incentives to provide discretionary execution services (e.g. upstairs trading) under MiFID, with unclear broader implications.

Being a sub-category of OTF, the broker/dealer running the BCS may also need to add an identifier for post-trade transparency requirements and report the daily number, value and volume of transactions. It will also add an identifier to transaction reports, to show when the transaction is executed on the system.

Box 9. Organised trading for OTC derivatives: EU and US discussions

Following the G20 commitments,143 _{the European Commission has proposed that “where} appropriate, trading in standardised144 _{OTC derivatives}145 _{[will] move to exchanges or} electronic trading platforms” (EU COM, 2010b, p.12). Besides the fact that some trading on fixed income products (bonds and structured products) and OTC derivatives takes already place through platforms registered as MTFs across Europe, the Commission – taking up the positions of the European Parliament (Langen, 2010) and CESR (2010g) – has proposed to introduce a new category of venue, the so-called ‘organised trading facilities’ (OTFs; EU COM, 2010b, p. 13). The Commission suggests that OTFs should meet the following conditions:

1) Non-discriminatory146 _{multilateral access;}

2) Support pre- and post-trade transparency obligations; 3) Report transactions to trade repositories; and

4) Have a dedicated facility for execution of trades.

For the consultation document, ESMA would set requirements to determine when a derivative is sufficiently liquid to be traded exclusively on OTFs or other organised venues. The decision could be based on liquidity measures such as frequency of trades and average size of transactions, as well as additional criteria such as the degree of investors’ participation. Ideally, requirements may need to coordinate with rules proposed for swap execution facilities (SEFs) in the US. Since the market for OTC derivatives is global, uncoordinated responses could create regulatory arbitrages.

Furthermore, rule-making should take into account that non-equity products (in particular, OTC derivatives) usually have a different market structure than equity markets (limit order books), with dealers posting executable quotes at investors’ request (Request For Quotes model; RFQ) or through bilateral transactions. The RFQ model is required by the nature of the transaction that is essentially bilateral, and by the nature of the demand that is mostly institutional and require a certain degree of customisation. A greater push towards standardisation and organised trading should balance benefits of a more transparent and orderly setting with costs entailed by lower availability of customised derivatives and so greater possibility to leave in the system some risk not properly hedged (Valiante, 2010, p. 45).147

Trading in bonds and structured products is already partially done on organised trading venues like MTFs, but transparency obligations do not necessarily apply to them, due to the exemption in MiFID (Recital 46). In effect, there is a risk that the requirements for

143 _{In particular, G 20, “Declaration on strengthening the financial system”, London Summit, 2 April 2009}

(http://www.londonsummit.gov.uk/resources/en/PDF/annex-strengthening-fin-sysm) and G 20, “Leaders’

Statement: The Pittsburgh Summit”, Pittsburgh Summit, 24-25 September 2009.

144 _{Standardisation is a multifaceted concept. It “refers to specific technical processes, economic and legal terms of} a financial product that allow a straight-through processing (STP) of a derivative transaction” (Valiante, 2010, p. 11). A product is standardised when the interaction between those aspects does allow an STP of the transaction. The use of electronic means is only one aspect of standardisation. Other relevant aspects are uniform contractual agreements and the use of plain vanilla terms, where possible.

145 _{For a definition, please see Section 4.4.5.}

146 _{The Commission does not clarify if ‘non-discriminatory’ should have the same meaning as ‘non-discretionary’,} as currently defined by MiFID for RMs and MTFs (recital 44).

147 _{CESR (2010g) believes that trading of standardised derivative products on organised trading venues is to be} encouraged by regulators, even though not mandated at this stage.

OTFs may overlap with those for MTFs, as they provide a execution service. The border between being qualified as a MTF rather than an OTF should be clearly spelled out. In order to promote more organised and transparent trading for non-equity asset classes, the Commodity Futures Trading Commission (CFTC) has proposed148 _{that those systems should} have robust risk controls and should display either indicative or executable quotes from members. In order to avoid unintended consequences for market structure, trading venues should be able to deploy both RFQ and electronic order book trading systems. In effect – for US regulators – this solution would allow a gradual shift from currently bilateral trading to SEFs by enhancing the opportunity for dealers to compete on executable quotes whenever possible, without necessarily undermining the management of their huge inventory positions (by publishing an indicative quote or falling under a large-in-scale waiver). The US proposal, at the moment, does not clarify whether these venues will have non-discriminatory access and pre-trade public transparency obligations, such as EU OTFs. The RFQ model under SEFs should have at least five market participants from which other participants can simultaneously request quotes. The order book model, if chosen by market participants, should develop a platform in which all of them can post bids and offers for other participants and decide with which of the displayed bids and offers transact.

Finally, in Europe, some trading platforms – registered as MTFs – have already started to bring together, through organised trading on order books, executable quotes and interests of dealers and other market participants that have chosen to stream their quotes on these platforms. Public pre-trade disclosure is limited to non-executable quotes, such as the mid- price.

Besides specific positions on market structure and how equity trading on an OTC basis currently occurs, there is a consensus that the quality of OTC data needs to be effectively improved, reducing inconsistencies (duplicative reporting) and increasing granularity (in particular, through the use of specific flags). Post-trade transparency requirements for OTC trading have been introduced by MiFID for the first time in many countries. According to CESR (2010b), up to 38% of EEA trades occur on an OTC basis, but it also recognises serious risks of misreporting and double-counting. These data are collected by Thomson Reuters from market data sources that collect themselves data as defined by MiFID. At such levels, OTC trading may raise doubts about its beneficial role in European capital markets. Some argue that this size – despite being historically high for Europe – contradicts the MiFID concept of OTC being an exceptional type of execution. Separately, since all OTC trading is by definition ‘pre-trade dark’, if this figure is correct, such level of non- pre-trade transparent trade may undermine market quality and price formation mechanisms.

However, there are two important caveats to the interpretation of this data. First of all, given the poor consistency and quality of OTC data, the publicly reported OTC may not be the same as what is actually traded OTC. Secondly, and even more importantly from the perspective of either of the two positions outlined above, CESR’s data only include the market share of OTC as reported through Markit BOAT or national exchanges. In effect, these data do not permit a trade-by-trade analysis or break down the overall 38% figure without assuming that no double-counting or misreporting exists (see

OTC trade disclosure

148 _{Commodity Futures Trading Commission (CFTC), “Core Principles and Other Requirements for Swap} Execution Facilities”, (www.cftc.gov).

0). These issues contribute to increasing uncertainty and opaqueness in the market. Without such an analysis, it is impossible to draw from the market share of the OTC alone any definitive conclusions about whether the OTC classification is being correct and whether, as a consequence, there is sufficient transparency and market quality in the market.

In this respect, a recent study (Nomura, 2010) reports an earlier investigation made by the UK Financial Services Authority (FSA) that estimates the share of reported OTC trades affected by double counting.

OTC breakdown

Figure 24. OTC ‘printed’ vs ‘actual’ equity trading

Source: FSA (from Nomura, 2010).

Since some trading venues are not officially recognised by MiFID and divergences exist between the regulatory and economic definition of trade, what the Directive considers as trade to be made transparent does not necessarily match the definition of trades that contribute to price formation. Therefore, there is a difference between what is ‘printed’ as defined by MiFID and what really contributes to price formation (‘actual trading’).

As suggested by the figure above, in the UK market, roughly 35-40% of OTC trading represents ‘give-ups’ from brokers,149 _{plus other categories of} trades that may not be considered as real liquidity, either price forming or informing. In addition, CESR (2010g) investigated other cases of double- counting or misreporting (see box below).

149 _{Give-up trades are orders executed by a broker (A) on behalf of another one (B), who is officially executing it} on behalf of a client. Since the order should be made by the broker B on behalf of the client, broker A should give up the trade (once executed) to broker B. In this way, the trade is printed when broker A buy shares on behalf of broker B and when the trades are given up and bought/sold by broker B in order to justify his/her execution to the client.

Box 10. OTC equity transaction type standards

In order to improve the quality of OTC trade reporting, CESR (2010g) has proposed the introduction of transaction type standards.150 _{These standards should increase granularity} and help at the same time to breakdown OTC trades into data that should be reconsolidated as either price forming or informing data, while avoiding double counting or misreporting.

Hence, CESR proposed a flag for each type of transaction below:

i) Benchmark trades (when price is calculated over time, as result of different variables, e.g. VWAP (volume-weighted average price);

ii) Agency cross trades;151 iii) Give-up/in trades;

iv) Ex/cum dividend trades; and v) Technical trades.152

In addition, in order to avoid double reporting due to the complex application of Art. 27.4 (implementing regulation), CESR clarifies that it should generally be the ‘executing broker’ that makes the report. If it is unclear who the ‘executing broker’ is, it should be the ‘selling investment firm’ to provide the report.

Therefore, the Committee has highlighted three potential sources of double-counted or misreported trades:

i) Riskless principal (the investment firm buying and selling on own account simultaneously to make the report);

ii) Agency cross (the investment firm ‘crossing’ the two trades should make the report); and

iii) Single/Multiple OTC transaction on behalf of a client (only the ‘selling’ investment firm or the trading platform where the trade has been sent should make the trade report, if not agreed otherwise).

An example of double reporting is when a client orders to buy 10 million shares at a guaranteed 2 hour VWAP. The investment firm decides then to split it into child orders of 6