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Questions and Answers on MiFID II and MiFIR Systematic Internaliser Regime
(Source: Questions and Answers on MiFID II and MiFIR market structures topics, ESMA70-872942901-38)
Question 1 [Last update: 03/11/2016]
By when will ESMA publish information about the total number and the volume of transactions executed in the Union and when do investment firms have to perform the assessment whether they should be considered as systematic internalisers for the first time in 2018 as well as for subsequent periods?
Commission Delegated Regulation of 25.4.2016 supplementing Directive 2014/65/EU of the European Parliament and of the Council as regards organisational requirements and operating conditions for investment firms and defined terms for the purposes of that Directive does not provide for any transitional provision which would allow the systematic internaliser regime to be fully applicable as of 3 January 2018. In the absence of such provisions, the first calculations are expected to be performed only when, in accordance with Article 17 of the Commission Delegated Regulation of 25.4.2016, there will be 6 months of data available.
In accordance with the clarifications provided below:
(i) ESMA will publish the necessary data (EU wide data) for the first time by 1 August 2018 covering a period from 3 January 2018 to 30 June 2018.
(ii) Investment firms will have to perform their first assessment and, where appropriate, comply with the systematic internaliser obligations (including notifying their National Competent Authority (NCA)) by 1 September 2018.
This timeline applies also to investment firms trading in illiquid instruments. While it is possible for those firms to carry out part of the test based on data at their disposal, the complete determination of the SI activity necessitates an assessment of the investment firms OTC-trading activity in a particular instrument in relation to overall trading in the Union. In order to ensure a consistent assessment and to ensure that all investment firms are treated in the same manner, for all instruments, irrespective of their liquidity status, the assessment should therefore be performed by 1 September 2018.
Similarly, although Commission Delegated Regulation of 25.4.2016 allows shorter look-back periods for newly issued instruments compared to the six months described above, ESMA considers that it is important to ensure a level playing field between all instruments and, therefore, suggests to apply the schedule proposed above also to newly issued instruments - i.e. first publication by ESMA of the necessary EU-wide data by 1 August 2018 and earliest deadline to comply, where necessary, with the SI regime set on 1 September 2018.
It is nevertheless important to stress that investment firms should be able to opt-in to the systematic internaliser regime for all financial instruments from 3 January 2018, for example, as a means to comply with the trading obligation for shares.
In accordance with Article 94 of MiFID II, the systematic internaliser definition and the transparency regime applicable to internalisers in shares admitted to trading on a regulated market under MiFID I will be repealed by MiFID II by 3 January 2018. Those firms, following the publication of the data of the first six months from 3 January 2018, will also have to determine whether their activity is frequent, systematic and substantial on the basis of the available data published in accordance with this note.
For subsequent assessments, ESMA intends to publish the necessary information within a month after the end of each assessment period as defined under Article 17 of the Commission Delegated Regulation of 25.4.2016 – i.e. by the first calendar day of months of February, May, August and November every year. After the first assessment, investment firms are expected to perform the calculations and comply with the systematic internaliser regime (including notification to their NCA) no later than two weeks after the publication by ESMA – i.e. by the fifteenth calendar day of the months of February, May, August and November every year.
Question 2 [Last update: 31/01/2017]
Do the calculations to identify if an investment firm is systematic internaliser have to be carried out at legal entity level or a group level? How are branches of investment firms being treated?
The definition of systematic internaliser under Article 4(1)(20) of MiFID II refers to "investment firms" established in the EU and, therefore, the calculations should be carried out at legal entity level. For EU investment firms operating branches in the Union, the activity of those branches would need to be consolidated for the purpose of the systematic internaliser calculations.
Question 3 [Last update: 31/01/2017]
i. Should investment firms, when determining if they are a systematic internaliser, include (i) transactions that are not contributing to the price formation process and/or are not reportable and (ii) primary market transactions?
ii. Should investment firms, when determining if they are a systematic internaliser, include trades executed on own account on a trading venue but following an order from the client?
iii. Are off order book trades that are reported to a regulated market, MTF or OTF under its rules excluded from the quantitative thresholds for determining when an investment firm is a systematic internaliser?
i. Article 13 of RTS 1 and Article 12 of RTS 2 exempt investment firms from reporting certain types of transactions for the purposes of post-trade transparency. ESMA is of the view that those types of transactions should not be part of the calculations for the purposes of the definition of the systematic internaliser regime, both for the numerator and the denominator of the quantitative thresholds specified in the Commission delegated regulation [add reference number once published on the OJEU]. The types of transactions included in Articles 13 of RTS 1 and 12 of RTS 2 are technical and cannot be characterised as transactions where an investment firm is executing a client order by dealing on own account. More importantly, the lack of a reporting obligation for those types of transactions would be a considerable challenge for competent authorities to supervise and for investment firms to comply with the systematic internaliser regime.
Primary market transactions in securities as well as creation and redemption of ETFs' units should not be included in the calculations.
ii. Article 12(6) of RTS 1 and in Article 7(7) of RTS 2 clarify that two matching trades entered at the same time and for the same price with a single party interposed are considered as a single transaction. An investment firm may, on the back of a client order, execute a trade on own account on a trading venue and back it immediately to the original client. While the trade can be broken down into two transactions - the first transaction executed on own account by the investment firm on the trading venue and the second transaction executed between the investment firm and the client - such transactions should be considered economically as one trade. ESMA is of the view that where the market leg is executed on a trading venue and immediately backed to the client at the same price, the investment firm is not deemed to execute a client trade outside a regulated market, an MTF or an OTF. Therefore, only one trade should be counted for the denominator for determining the systematic internaliser activity (total trading in the EU), and no trade should be included in the numerator when determining whether an investment firms is a systematic internaliser.
However, in case the market leg transaction is not immediately backed to the client or in case the price is not the same, the trades should be counted as two for the denominator and the trade with the client should be counted for the numerator.
iii. An investment firm dealing on a trading venue is not deemed to act as a systematic internaliser. A trading venue is a multilateral system that operates in accordance with the provisions of Title II of MiFID II concerning MTFs and OTFs or the provisions of Title III concerning regulated markets. According to recital (7) of MiFIR a market which is composed by 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.
A transaction is deemed to be executed on a trading venue if it is carried out through the systems or under the rules of that trading venue. There is no requirement for the transactions to be executed on an electronic order book for the trade to be subject to the trading venue's rules. Therefore, only off order book transactions that benefit from a waiver from pre-trade transparency should be considered as executed on a trading venue, and should not count for the numerator when determining whether an investment firm is a systematic internaliser.
Question 4 [Last update: 31/01/2017]
i. On which level is the systematic internaliser threshold to be calculated for derivatives? On a sub-class level or on a more granular level?
ii. On which level is the systematic internaliser threshold to be calculated for structured finance products (SFPs)?
iii. What constitutes a 'class of bonds' under Article 13 of Commission Delegated Regulation of 25.4.2016 supplementing Directive 2014/65/EU of the European Parliament and of the Council as regards organisational requirements and operating conditions for investment firms and defined terms for the purposes of that Directive? Do senior, subordinated or convertible bonds from the same issuer constitute different classes?
i. The calculation should be performed at the most granular class level as identified in RTS 2. Where an investment firm meets the thresholds for such a class, it should be considered as a systematic internaliser for all derivatives within that most granular class.
With respect to equity derivatives, the sub-classes as defined in Table 6.2 of Annex III of RTS 2 for LIS and SSTI should be used.
ii. For SFPs, calculations should be performed at ISIN level and where, for a specific ISIN, an investment firm is above the thresholds prescribed, it should be considered a systematic internaliser for all SFPs issued by the same entity or by any entity within the same group.
iii. A class of bonds issued by the same entity, or by any entity within the same group is a subset of a class of bonds in table 2.2 of Annex III of RTS 2 (sovereign bond, other public bond, convertible bond, covered bond, corporate bond, other bond). Hence, where an investment firm passes the relevant thresholds in a bond it will be considered to be a systematic internaliser in all bonds belonging to the same class of bonds according to table 2.2. of Annex III of RTS 2 issued by the same entity, or by any entity within the same group.
It is therefore possible to distinguish between, for instance, corporate bonds and convertible bonds as different classes of bonds, but the debt seniority of a bond does not constitute a different class.
Question 5 [Last update: 31/01/2017]
i. Can systematic internalisers meet their quoting obligations under Article 18(1) of MiFIR
for liquid instruments by providing executable quotes on a continuous basis?
ii. Can client orders routed by an automated order router (AOR) system be considered as 'prompting for a quote' according to Article 18(1)(a) of MiFIR?
iii. For how long should quotes provided by systematic internalisers be firm, or executable?
i. The systematic internaliser regime for non-equity instruments is predicated around a protocol whereby the systematic internaliser provides a quote or quotes to a client on request. However, nothing prevents the systematic internaliser, especially in the most liquid instruments, to stream prices to clients. Where those prices are firm, i.e. executable by clients up to the displayed size (provided the size is less than the size specific to the instrument), the systematic internaliser would be deemed to have complied with the quoting obligation under Article 18(1) of MiFIR. The systematic internaliser can, in justified cases, execute orders at a better price than the streaming quote.
ii. Yes. The provisions in Article 18 of MiFIR are neutral concerning the technology used for prompting quotes. A systematic internaliser can be prompted for and provide quotes through any electronic system.
iii. The quote should remain valid for a reasonable period of time allowing clients to execute against it. A systematic internaliser may update its quotes at any time, provided at all times that the updated quotes are the consequence of, and consistent with, genuine intentions of the systematic internaliser to trade with its clients in a non-discriminatory manner.
Systematic internalisers and riskless transactions
Question 15 [Last update: 03/04/2017]
Recital 19 of the Commission Delegated Regulation (EU) 2017/565 clarifies the conditions under which an SI may engage in matched principal trading to execute client orders. To what extent can SIs engage in other types of riskless back-to-back transactions?
Recital 19 of the Commission Delegated Regulation (EU) 2017/565 is not limited to internal matching of client orders through matched principal trading but more generally prevents SIs from operating any system that would “bring together third party buying and selling interests in functionally the same way as a trading venue”. The prohibition for an SI to operate an internal matching system for matching client orders is just one example, as opposed to the unique circumstance, under which an SI would actually be operating functionally in the same way as a trading venue and would be required to seek authorisation as such.
Based on the SI definition provided in Article 4(1)(20) of MiFID II, ESMA understands that the trading activity of a SI is characterised by risk-facing transactions that impact the Profit and Loss account of the firm. By undertaking such risk-facing transactions, SIs are a valuable source of liquidity to market participants. In that regard, ESMA notes that the MiFIR pre-trade transparency provisions for SIs seek to avoid submitting SI to undue risks based on the assumption and understanding that SIs are indeed facing risks when trading.
In contrast to the above, ESMA is of the view that arrangements operated by an SI would be functionally similar to a trading venue where they meet the following criteria:
a) The arrangements would extend beyond a bilateral interaction between the SI and a client, with a view to ensuring that the SI de facto does not undertake risk-facing transactions. This would be the case, for instance, where an SI would have agreements with other liquidity providers so that the SI would do a riskless back-to back transaction with one of those liquidity providers whenever a transaction is executed with a client, or where it would only execute one transaction contingent on another one. A similar outcome would be reached from the reverse situation where one or more liquidity providers would be streaming quotes to an SI. The quotes would then be forwarded by the SI to its clients to be executed against, resulting again in no risk back-to-back transactions which could involve multiple parties
By crossing client trading interests with other liquidity providers’ quotes, via matched principal trading or another type of riskless back-to-back transaction, so that it is de facto not trading on risk, the SI would actually organise an interaction between its client orders on the one hand and the SI or other liquidity providers’ quotes on the other hand. The SI would be bringing together multiple third party buying and selling trading interests in a way functionally similar to the operator of a trading venue.
b) The arrangements in place are used on a regular basis and qualify as a system or facility, as opposed to ad-hoc transactions. The existence of a system would be easily identified where, for instance, the arrangement in place would be underpinned by technological developments to increase speed and efficiency and legal agreements would be in place between the SI and liquidity providers. The operation of a system could also include circumstances where there is an understanding with third parties that trade by trade hedging will be available on a regular basis. ESMA recalls that MiFID II/MiFIR is technology neutral and applies to voice systems as well as to electronic and hybrid systems;
c) The transactions arising from bringing together multiple third party buying and selling interests are executed OTC, outside the rules of a trading venue.
ESMA highlights that the above does not prevent SIs from hedging the positions arising from the execution of client orders as long as it does not lead to the SI de facto executing non risk-facing transactions and bringing together multiple third party buying and selling interests. ESMA is of the view that an SI would not be bringing together multiple third party buying and selling interests as foreseen in Recital 19 where hedging transactions would be executed on a trading venue.
Question 16 [Last update: 03/04/2017]
Recital (19) of the Commission Delegated Regulation (EU) 2017/565 foresees that a SI can undertake matched principal trading provided it does so on an occasional, and not a regular, basis. How is “occasional basis” expected to be assessed?
As stated under Answer 15, ESMA is of the view that a SI activity is characterised by risk- facing transactions that impact the Profit and Loss account of the firm.
Where an SI would receive, and execute, two potentially matching buying and selling interests from clients as one matched principal trade or where it would try to find the buyer for a sell order (or the other way around) and execute the first leg contingent on the second leg, those transactions would not qualify as risk facing transactions. As such, they could only be executed by an SI on an occasional basis, as provided for by Recital (19) of the Commission Delegated Regulation (EU) 2017/565.
ESMA is of the view that an SI would not be undertaking matched principal trading on an occasional and non-regular basis if it meets any of the following criteria:
a) the investment firm operates one or more systems or arrangements, be they automated or not, intended to match opposite client orders. The investment firm may accidentally receive two opposite matching buying and selling interests and match them but it should not have systems in place aimed at increasing opportunities for client order matching;
b) when executing client orders, non-risk facing activities account for a recurrent or significant source of revenue for the investment firm’s trading activity;
c) the investment firm markets, or otherwise promotes, its matched principal trading activities.
Question 19 [Last update: 07/07/2017]
Should a system providing quote streaming and order execution services to multiple SIs be authorised as a multilateral system?
Articles 14(1) and 18(1) of MIFIR require SIs to make public firm quotes, which may be published through an APA. Some prospective APAs propose setting up arrangements which, on top of their APA services, provide a suite of quote streaming and order execution services to SIs and their clients. Clients cannot interact with more than one SI via a single message but can send multiple messages to multiple SIs participating in the service provided.
Article 4(19) of MiFID II defines a multilateral system as” [...] any system or facility in which multiple third-party buying and selling trading interests in financial instruments are able to interact in the system”. Article 1(7) of MiFID II requires all multilateral systems to operate as either a RM, an MTF or an OTF.
In line with the criteria set out in Q&A 3 on OTFs published on 3 April 2017 for identifying multilateral trading systems, ESMA notes that:
a) If a system allows multiple SIs to send quotes to multiple clients and allows clients to request execution against multiple SIs, then this meets the interaction test foreseen in Article 4(1)(19) even if there is no aggregation across individual SI quote streams;
b) The arrangements described above have the characteristics of a system as they are embedded in an automated facility; and,
c) Those arrangements are not limited to pooling potential buying and selling interests from SIs but also cater for the direct execution of the selected SI quotes. Genuine trade execution would be taking place on the system provided.
Accordingly, a system that provides quote streaming and order execution services for multiple SIs should be considered a multilateral system and would be required to seek authorisation as a regulated market, MTF or OTF in accordance with Article 1(7) of MiFID II.
ESMA reminds that if a firm were to arrange transactions on one system and provide for the execution of the transactions on another system, the disconnection between arranging and executing would not waive the obligation for the firm operating those systems to seek authorisation as a trading venue.