With the recent publication by the European Commission of the Mifir legislative proposal, the headlines have focused on the provisions for establishing a real-time consolidated tape for EU markets.
While the consolidated tape certainly marks a major step forward for the capital markets union (CMU), markets participants themselves are more focused on the extent to which EU and UK markets diverge, if only for the simple reason that the extra complexity of a dual regime means extra costs.
“A key question surrounds the extent to which the UK diverges from Europe,” said Phil Lloyd, head of customer sales delivery at NatWest Markets. “At the macro level, the UK is more prone to follow a principles-based approach, while the EU will continue with a more rules-driven approach.”
According to Lloyd, for markets the UK-EU divergence will have a cumulative effect in areas such as liquidity and operational complexity. For example, the EU’s Mifir review proposes to get rid of the size specific to the instrument (SSTI) waiver for non-equity instruments, while changing the large-in-size (LIS) levels and deferrals, in a bid to make them simpler and meet the original transparency objectives.
The original aim of the SSTI waiver was to make sure liquidity provider aren’t exposed to undue risk and factor in whether the relevant market participants are retail or wholesale investors.
“Mifid II/Mifir is generally seen as a complex regulation, so the simplifications seem sensible,” Lloyd added. “How that differs from what the UK wants to do is something markets will have to watch closely in the coming months as the results of the wholesale markets review (WMR) consultations come out.”
The way the EU’s Mifir legislative proposal seeks to tighten requirements for trading on non-pre-trade transparent venues, such as systematic internalisers (SI), contrasts with the UK approach, which is widely seen as much more dark trading and SI-friendly.
“The Mifir proposals clarify the EU’s view on venues such as SIs and dark multilateral trading facilities (MTFs),” said Gareth Exton, head of execution and quantitative services distribution EMEA at Liquidnet. “The EU regulators feel that the best place to trade is in lit pre-trade transparent markets. However, the UK Treasury’s wholesale markets review (WMR) sets out quite a different path.”
The WMR path entails being “happier” with a higher proportion of the total volume traded in the dark, according to Exton. Now, the focus is on how the UK will respond to the Mifir proposals, and whether it will tighten the rules around UK SIs or liberalise them further, Exton added.
“The EU has been pushing for trading to happen on primary listing exchanges, which they believe provides price formation, but this is not completely accurate,” said Keshava Shastry, head of capital markets and systematic investment solutions at DWS – previously known as Deutsche Asset and Wealth Management.
According to Shastry, other trading venues, such as MTFs and SIs, can in certain contexts provide diversified liquidity pools and better execution. “MTFs, dark pools and SIs do have their own place and do provide benefits for market participants, as recognised by the UK regulators and the marketplace,” he added. “Not everything is good for everybody.”
To what extent firms should be allowed to trade in the dark as opposed to on lit venues is a long-standing debate, and one that is difficult to resolve. The buyside tends to think that providing investors with a competitive marketplace and choice makes for a more cost-efficient market structure. Alternative venues arose because market participants wanted less market information leakage when a big drop happened, and didn’t want to be seen by the rest of the market.
“Lit versus dark is definitely a divergence area,” said Shastry. “While the EU seeks to push volumes onto primary listing venues, the UK is taking a broader view of the benefits of alternative venues.”
He added: “It is worth remembering that SIs and dark MTFs are still required to provide post-trade transparency. There are also various deferrals in place for when trades need to be reported. As markets evolve and some securities become more liquid, it is expected that certain thresholds will be reviewed on both sides of the channel.”
“As a fully lit electronic venue, we both support and appreciate the benefits of Mifid II/Mifir, but we also understand that you need biodiversity in financial markets,” said Jennifer Keser, head of regulation and market structure for Europe at Tradeweb. “For example, the straightforward model of multiple request for quote (RFQ) may not make sense for all trade types or asset classes.”
Bob Penn, partner at Allen & Overy, struck a more critical note. “Europe has never felt comfortable with quote-based trading,” he said. “Its cultural background is more based on bourses and order books. That’s why there is such a wonky-looking market structure coming out of the EU: it still struggles with non-equity markets.”
For Penn, this manifests itself in measures such as the imposition of increasingly onerous requirements for off-venue liquidity provision. According to him, the EU’s adversity to non-order-book non-pre-trade-transparent trading will remain an important theme, even in the context of increased regulatory competition with the UK.
“The UK understands better the risks that liquidity providers take in a more transparent environment,” he added.
The main impact of a divergent approach is widely seen as adding complexity in terms of having to trade differently on different markets. As the UK and EU drift further apart, the places where market participants find liquidity and have the right tools at their disposal will likely change, too.
“Brokers and algorithm providers will have to embed all of this complexity into their models for how they trade an EU versus a UK security,” said Liquidnet’s Exton. “This makes it more complicated for buyside traders to trade securities in different markets. Complexity equals more cost, be it in time, knowledge, or the technology spend needed to support the two regimes.”
Allen & Overy’s Penn highlighted reporting and disclosure systems as major concerns for firms operating under a double playbook. To implement Mifid II, he said, firms have already spent huge amounts of money building the necessary operational infrastructure.
“I’m not sure twiddling around the edges of transparency rules will achieve anything substantial, except the writing of large cheques by firms who now have to update their systems,” he added.