Process trades have been around in various forms for years, but under Mifid II they’ve gained new prominence. While their definition is seemingly clear, uncertainty persists around everything from execution timings and methods, to unanswered questions from Esma.
Why is this important?
As is well known by now, Mifid II’s overarching ambition is to improve transparency, bringing light to some of the darker corners of European capital markets. With it came the concept of the trading obligation for various instruments including certain derivatives, provided they are both sufficiently liquid and available for trading on at least one trading venue. Regulators’ thinking was that for deals at the smaller end of the spectrum, highly liquid instruments really don’t need to be traded in the dark.
But they accepted that when it comes to less liquid, less frequently traded instruments and/or large in scale (LIS) deals, off-venue trading still has an important role to play. So they introduced an exemption to the pre-trade transparency rules if a transaction satisfies one or both of those thresholds.
“If one wants to trade a €1 billion notional in an instrument subject to the trading obligation, they weren’t just going to send a blind RFQ
This is where process trades come in. Many in the market argue that Mifid II’s (unspoken but implied) goal of shifting the majority of trades onto venues is inconsistent with the way vast parts of Europe’s debt and derivatives markets work. Process trades allow price discovery to take place away from a venue, while still enjoying the transparency and reporting benefits of executing on one.
But executing on-venue has plenty of other benefits in addition to compliance with Mifid II. Process trades are not a Mifid construct; they’ve been allowing traders to reap the benefits of straight through processing (STP) feeds, providing same-day settlement, that come only from executing on a venue for years now. They also appear under a different guise but vastly similar form in the context of block futures.
“Clients have been doing process trades for years to enjoy the efficiency and STP benefits of trading on a venue, but they have absolutely become significantly more popular since Mifid II now that they also get the benefit of MTF trade reporting,” says Gareth Coltman, head of product management at MarketAxess.
So what is a process trade?
All the market participants that spoke to Practice Insight agree that a process trade – also referred to as off-book-on-venue in some circles – can be broadly defined as a trade that is pre-agreed between two counterparties bilaterally, away from a venue (usually over the phone), then shifted onto a venue to be executed under the rules of that venue or exchange.
What’s most important is the time of execution, which is, in the eyes of regulators and market participants, when the trade is booked on the venue. Nicholas Bean, global head of trading venues at Bloomberg, says he has spent a long time educating members on this point. That’s important because pre-trade transparency would kick in during the phone conversation otherwise, but also – and this is where Bean thinks understanding is still lacking – because venues also have a market abuse surveillance obligation to honour.
“We urge participants to ensure the time difference between the voice conversation and venue execution is as slim as possible,” says Bean. “Prices can move which may mean a counterparty will not be in a position to honour the conversation. It’s also important because venues’ surveillance obligation includes appropriate pricing.”
Process trades can, according to Silvano Stagni, a member of the FIX Trading Community’s working group, be viewed as a sort-of halfway house between over-the-counter (OTC) and voice-based, and on-venue, electronic trading. “There are a lot of people who were reluctant to abandon voice altogether and go completely electronic, so they came up with using process trades here and it’s actually caught on,” he says. “To me, voice trading is not necessarily sustainable though, because voice is so complicated when it comes to timestamping.”
Stagni thinks those same conversations that some argue must take place over the phone could easily happen over an online chat, which would also improve recordkeeping and, of course, transparency.
MarketAxess’ Coltman has noticed clients becoming more comfortable with electronic trading for a broader range of products particularly over the last couple of years, and usually getting a better execution result by going to a broad range of possible counterparties.
But not everyone agrees that process trading has a limited shelf life. Many view process trades as less of an intermediate step than an alternate solution, one which will continue to play an important role even in light of the broader shift to all-electronic for other instruments. “I think there are some trades where people are always going to want to do their price discovery over the phone, in the same way as they will always want to do others electronically,” says Simon Maisey, head of business development at Tradeweb. “This just allows them to have a single process across both options.”
Barclays’ Coupe adds: “Process trades allow traders to get additional context about how to position a deal, while still embracing the spirit of Mifid II.”
But some are a little more sceptical. “They’re not in any way wrong, but it would be a shame if process trades swallow whole parts of the market,” said one London-based private practice source. “Pre-trade transparency is valuable, and it’s often lost in this scenario.
How does it actually work?
Depending on who you speak to, there are either one or two types of process trade. Tradeweb for instance offers two services: process indicative trade (PIT) and process agreed trade (PAT). “We were keen to offer flexibility within the regulatory framework, and to address members’ concerns around the difference between a risk transfer and the formal conclusion of a trade,” explains Uwe Hillnhütter, the firm’s Mifid II implementation director.
Barclay’s Coupe agrees that there are two types; the key difference being that in an indicative process trade, the price is not locked in, whereas it must be honoured for an agreed trade. But in both cases, the trade is not legally executed until it’s on the venue. An indicative quote also means there’s no obligation to provide pre-trade transparency, whereas a firm quote would trigger it.
Tradeweb says that for its PAT option, which is less popular with members than PIT, the trade must take place on-venue within 15 minutes of agreeing it over the phone. But for indicative trades, Hillnhütter argues that the venue doesn’t actually know how many minutes ago the conversation took place, so a time limit would be somewhat arbitrary.
Meanwhile both MarketAxess and Bloomberg’s rulebooks say the trade must be submitted to its MTF ‘as soon as technologically practicable’ or similar, but in any event within 15 minutes of it being arranged.
Buyside firms must clearly mark the trade to make clear it’s not just a generic RFQ when submitting it to the venue, which is usually in the form of a tick box. “If it’s not marked as a process trade then it’s simply not a process trade. And that’s very important, as some people may think they’re doing them, but without following the protocol,” says Coupe. “And if it’s not being reported properly then the data is irrelevant. Standardisation across venues would help here.”
How does that square with best execution obligations?
Mifid II also introduces the concept of best execution, which buyside firms must prove to their clients in a quarterly report listing the top five execution venues for that particular instrument. Best execution reports have their own issues, but some have raised the concern that by pre-agreeing to trade with one chosen liquidity partner, firms won’t necessarily be getting the best price possible.
But best execution is not just about price. “Going straight for pricing doesn’t always mean you’re getting best execution – it’s also about speed and quality of execution,” argues one buyside source.
Most MTFs also offer an ability to capture supplementary information to support best execution reports, including telephone quotes from other dealers.
What do regulators say about it?
On the official channels, regulators have been relatively silent on process trades, though in February Esma released some guidance in the form of a Q&A which reads:
“While Mifir does not have specific provisions for negotiated or pre-arranged transactions for non-equity instruments, ESMA considers it nevertheless possible to formalise negotiated or pre-arranged transactions on a trading venue subject to meeting the conditions for the respective waivers from pre-trade transparency set out in Article 9(1) of Mifir.”
In that same Q&A Esma also made clear that the solution can only be used for LIS, illiquid deals; prior to that some venues had considered making it available to all types of orders. But plenty in the market still feel that more regulatory guidance would be helpful.
“There are still questions Esma needs to answer,” says FIX’s Stagni. “For instance, does a normal RFQ process, done in a mix of voice and electronic, have to be handled differently from an RFQ which is done either all-voice or all-electronically?”
One EU national regulator told Practice Insight that trading venues, associations and market participants raised the question of process trades in the run-up to January 3. “We used those conversations to explain what was and was not permissible, and based on those conversations and the Esma Q&A, we believe the market has enough information to understand how process trades work under Mifid II,” a spokesperson says.
Esma did not respond to a request for comment for this piece.