|Organised Trading Facility (OTF)|
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Organised trading facility (OTF) is a multilateral system, which is not a regulated market or MTF and in which multiple third party buying and selling interests in bonds, structured finance product, emissions allowances or derivatives are able to interact in the system in a way which results in a contract.
OTF are regulated in the provisions of Title II of the MiFID II Directive, thus operating an OTF is classified as an investment service.
As a consequence, only persons licensed as an investment firm under MiFID are entitled to run an OTF (operation of an OTF is included in the Section A (investment services and activities) of the MiFID II Annex I point 9).
The creation of the OTF category was expected to bring systemic benefits, in particular aid the price formation process in bonds and derivatives as well as enhance the resilience of the systems being used for the trading of these instruments.
The conception for OTF is broad and includes a multitude of electronic platforms that were not so far subject to requirements applied to regulated markets and MTFs, for this reason an OTF is often perceived as a catch-all category of a trading venue.
However, it needs to be noted that "recital 8 of MiFIR clarifies that an OTF should not include facilities where there is no genuine interaction of trading interest, such as bulletin boards used for advertising buying and selling interests, other entities aggregating or pooling potential buying or selling interests, electronic post‑trade confirmation services, or portfolio compression. Any system that only receives, pools, aggregates and broadcasts indications of interest, bids and offers or prices shall not be considered a multilateral system for the purpose of MiFID II. This is because there is no reaction of one trading interest to another other within these systems – they do not 'act reciprocally'" (Financial Conduct Authority, Markets in Financial Instruments Directive II Implementation – Consultation Paper I, December 2015, CP15/43, p. 49).
Voice trading systems
UK HM Treasure in the MiFID II Consultation Impact Assessment (p. 3) said:
"MiFID II adds one new investment service and activity: operation of an Organised Trading Facility (OTF). An OTF is the platform for multilateral trading interests to interact leading to transactions in the financial instrument. However, in contrast to an MTF where the operator of the platform plays a neutral role in bringing about transactions, the operator of OTF plays an active role in bringing together buying and selling counterparties and helping them to negotiate the terms of a trade. This will often involve voice trading where the operator contacts counterparties by telephone or electronic communications to develop a transaction."
Also ESMA underlined that MiFID II is technology neutral and the OTF definition includes voice trading in the same way as the definition of regulated markets and MTFs include voice trading systems.
Therefore, an investment firm executing transactions through voice negotiation would be considered as falling under the definition of an OTF where the arrangements in place would meet the aforementioned general conditions.
Regulated markets and MTFs vs. OTFs - comparison
A common feature of all trading venues, namely regulated markets, MTFs, and OTFs, is the requirement to lay down transparent and non discriminatory rules governing access to the facility.
However, while regulated markets and MTFs are subject to similar requirements regarding whom they may admit as members or participants, OTFs are able to determine and restrict access based inter alia on the role and obligations which they have in relation to their clients.
In this regard, OTF may specify parameters governing the system such as minimum latency provided this is done in an open and transparent manner and does not involve discrimination by the platform operator.
OTFs follow similar organisational requirements to MTFs, however, OTFs have a number of a distinct features:
- OTFs may only trade in bonds, structured finance products, derivatives and emission allowance (non-equity instruments);
- there are less stringent limitations to the type of activities that the operator of the OTF may undertake both in relation to matched principal trading and trading on own account (additional restrictions apply as an OTF and a systematic internaliser (SI) cannot be operated by the same legal entity);
- as opposed to regulated markets and MTFs governed by non-discretionary rules, the OTF operator must must play an active role in bringing about transactions on its platform and exercise discretion either when deciding to place or retract an order on the OTF and/or when deciding not to match potential matching orders available in the system;
- as opposed to regulated markets and MTFs that have members or participants, OTFs have clients (as a consequence, transactions concluded on OTFs have to comply with client facing rules, including best execution rules, regardless whether the OTF is operated by an investment firms or a market operator); and
Discretionary order execution
While regulated markets and MTFs have non-discretionary rules for the execution of transactions, the operator of an OTF carries out order execution on a discretionary basis subject, where applicable, to the pre-transparency requirements and best execution obligations (this is without prejudice to the fact that, because an OTF constitutes a "genuine trading platform", the platform operator should be neutral - Recital 9 MiFIR).
Discretionary order execution is potentially the most vague and ambiguous element of the OTF's regulatory set-up.
Intuitively, the application of discretion may be particularly interesting if put against the background of the neutrality, the OTF is required to preserve.
Pursuant to MiFIR the market operator or investment firm operating an OTF are required to "make clear to users of the venue how they will exercise discretion."
An investment firm or market operator operating an OTF can only exercise discretion in the following circumstances (Article 20(6) of MiFID II):
(b) when deciding not to match a specific client order with other orders available in the systems at a given time, provided it is in compliance with specific instructions received from a client and with its obligations in accordance with Article 27 of the MiFID II (obligation to execute orders on terms most favourable to the client).
The discretion must be exercised at either or both of the above levels (the aforementioned FCA Consultation Paper I of December 2015, CP15/43, p. 114).
For the system that crosses clients' orders the OTF operator may decide if, when and how much of two or more orders it wants to match within the system.
The OTF operator may facilitate negotiation between clients as to bring together two or more potentially compatible trading interests in a transaction.
ESMA has issued an extensive guidance on what is meant by the discretionary order execution by the OTFs - see Questions and Answers on MiFID II and MiFIR market structures topics, 5 April 2017, ESMA70-872942901-38.
Firstly, ESMA has explained that the exercise of any form of discretion does not automatically mean that a venue is an OTF.
Further, referring to the aforementioned MiFID II Article 20(6), ESMA analysed in greater detail what is covered by the exercise of discretion at each of the respective levels: a) order discretion and b) execution discretion.
With respect to exercise of discretion by the OTF a number of specific issues arose.
ESMA with this respect also differentiated legal circumstances at an order level and at a transaction level.
Discretion at order level does not have to be exercised by the OTF order by order.
As an example, the OTF operator may consider, at a given point in time that some or all orders of a specific size in a specific instrument should be retracted from the OTF as more favourable conditions are temporarily available elsewhere.
However, the OTF operator must have the ability to exercise discretion at order level if circumstances so require, for instance in case of prior execution of an order on another trading venue.
Conversely, at execution level, discretion whether not to match two potential matching buying and selling interests can only be meaningfully exercised by the OTF at order level.
Another problem was whether the use of a fully automated system excludes the exercise of discretion and should therefore be automatically classified as an MTF.
ESMA answered to this question in the negative.
MiFID II is ‘technology neutral’ and permits any trading protocol to be operated by an OTF, provided it is consistent with fair and orderly trading and the exercise of discretion.
Tthe exercise of discretion as to if and when to place or retract an order could possibly be automated through artificial intelligence and algorithms, without necessarily the exercise of human judgement on a case by case basis.
Conversely, human intervention is not necessarily sufficient to prove the exercise of discretion.
Human intervention that is not based on the exercise of human judgement (for instance, only consisting in the random placing or retracting or matching/non-matching of orders) would not be considered as the exercise of discretion.
When discretion is exercised at execution level, i.e. when deciding if, when or how much of two or more trading interests should (or should not) be matched, the exercise of discretion would not preclude the use of automated systems, provided that certain conditions are met.
In particular, the sophisticated algorithms supporting automated matching would need to anticipate the circumstances under which the orders would not be matched; they would also have the capacity to ensure that the decision to match (or not to match) two opposite trading interests is in compliance with the best execution policy or a client specific instruction.
As one of the differentiating factors from execution algorithms operated by MTFs, the algorithms operated by the OTF would be expected to take into account external market factors or other external source of information to demonstrate the exercise of discretion.
Regulatory regime for OTF
MiFID II supplemented Annex I Section A of MiFID I (containing the list of investment services and activities) with point 10 which reads: "Operation of Organised Trading Facilities".
Hence, there should be no ambiguities that the operation of an OTF represents an investment service in the MiFID II meaning and, consequently, requires an investment firm licence.
The following effect is that market operator authorised to operate an OTF must ensure compliance with the provisions in Chapter 1 of the MiFID II regarding Conditions and Procedures for Authorisation for Investment Firms.
Hence, contrary to MTF, the following articles of the MiFID II Directive are applicable to the transactions concluded on an OTF:
Moreover, a relevant operator operating an OTF must provide its competent authority the rules and procedures to ensure compliance with the said Articles 24, 25, 27 and 28 of MiFID II for transactions concluded on the OTF where those rules are applicable to the relevant operator in relation to an OTF user (Article 6(e) of the Commission Implementing Regulation (EU) 2016/824 of 25 May 2016 laying down implementing technical standards with regard to the content and format of the description of the functioning of multilateral trading facilities and organised trading facilities and the notification to the European Securities and Markets Authority according to Directive 2014/65/EU of the European Parliament and of the Council on markets in financial instruments).
The novelty in the design of the OTF as the regulated entity was presumably at the origin of the rule stipulating that the competent authority may require, either when an investment firm or market operator requests to be authorised for the operation of an OTF or on ad-hoc basis, a detailed explanation why the system does not correspond to and cannot operate as a regulated market, MTF, or systematic internaliser and a detailed description as to how discretion will be exercised, in particular when an order to the OTF may be retracted and when and how two or more client orders will be matched within the OTF.
In addition, the investment firm or market operator of an OTF is obliged to provide the national competent authority with information explaining its use of matched principal trading.
Moreover, pursuant to Article 2(2)(d) of the said Commission Implementing Regulation (EU) 2016/824 of 25 May 2016, a relevant operator has an obligation to provide its national competent authority with a detailed description of the functioning of its trading system specifying, among others, "a description explaining how the trading system satisfies each element of the definition of an OTF."
Further, market operator is required to provide information on:
Transparent and non-discriminatory OTFs' access rules
Article 18(3) of MiFID II requires that investment firms and market operators operating an OTF establish, publish and maintain and implement transparent and non-discriminatory rules, based on objective criteria, governing access to its facility.
The brief overview of the non-exhaustive list of arrangements which are considered non-objective and discriminatory has been given by the EU financial market watchdog in the Questions and Answers on MiFID II and MiFIR market structures topics of 7 July 2017 (ESMA70-872942901-38).
In the document ESMA said:
a) OTFs should not require members or participants to be direct clearing members of a CCP.
Given the protections afforded to non-clearing members under MiFIR and EMIR, as well as the rules on straight through processing (STP), an OTF should not require all its members or participants to be direct clearing members of a CCP.
OTFs may however require members or participants to enter into, and maintain, an agreement with a clearing member as a condition for access when trading is centrally cleared.
b) For financial instruments that are centrally cleared, OTFs should not allow members or participants to require other members or participants to be enabled before they are allowed to trade with each other.
There are legitimate checks that a OTF might carry out before allowing a member or participant on to their venue.
For example, in markets for non-centrally cleared financial instruments OTFs may wish to carry out credit checks, or ensure that a member or participant has appropriate capital to support the positions it intends to take on the OTF.
In a non-centrally cleared derivatives market, there may be a need for bilateral master netting agreements to be in place between participants before the OTF can allow their trading interests to interact.
OTFs will also need to be comfortable that potential participants are meeting the regulatory requirements to be a member of an OTF such as having appropriate systems and controls to ensure fair and orderly trading.
However, in centrally cleared markets, enablement mechanisms whereby existing members or participants of an OTF can decide whether their trading interests may interact with a new participant’s trading interest are considered discriminatory and an attempt to limit competition.
Enablement mechanisms also reduce the transparency around the liquidity available on different trading venues.
c) OTFs should not require minimum trading activity.
OTFs should not require minimum trading activity to become a member or participant of a trading venue, as this could restrict the access to the OTFs to large members or participants.
d) OTFs should not impose restrictions on the number of participants that a participant can interact with.
In a request for quote (RFQ) protocol, a OTF should not impose limits on the number of participants that a firm can request a quote from.
Whilst a firm requesting a quote may, in compliance with Article 28 of MiFID II, want to limit the number of participants it requests quotes from in order to minimise the risk of unduly exposing its trading interest, which could result in it obtaining a worse price, this should not be mandated by the OTF.
For instance, where a smaller firm is requesting a quote to execute a low volume trade, it might be less concerned about the risks of exposing its trading interest, and so happier to request quotes from a larger number of market makers or liquidity providers.
Limiting the number of participants a firm can request quotes from risks restricting the ability of market participants to access liquidity pools, and only sending requests to traditionally larger dealers who they assume might have larger inventories.
This simultaneously restricts the ability of the requestor to access the best pool of liquidity and reduces the likelihood of a smaller dealer receiving requests, despite it having a strong trading interest.
Application of the best execution policy in an OTF
ESMA has explained that where an investment firm operates an OTF, the investment firm’s best execution should cover how orders are executed both at the level of the investment firm and at the level of the OTF and, in particular, how discretion is exercised at each stage.
Firstly, an investment firm operating an OTF should, in the same way as other investment firms that execute client orders, have a firm-level execution policy setting out the various execution venues, including its own OTF, that it will be considering when receiving a client order and explain in which circumstances an execution venue would prevail over the others.
Secondly, the investment firm should have either a separate policy or an additional section in the firm-level execution policy governing how, when a client order is sent to the OTF, the best possible result for the client is achieved taking into account the trading interests in the system and the different execution mechanisms that may be available on the OTF, such as voice execution, electronic RFQ or order book.
As the exercise of discretion by the investment firm in its OTF operator capacity is to be in compliance with its execution policy, the document should also set out in details the area(s) in which the OTF operator intends to exercise discretion and the basis on which such discretion will be exercised (Article 20(6) of MiFID II).
Equivalent requirements apply to a market operator operating an OTF.
In this regard, a market operator would need to have a best execution policy in place, setting out the conditions under which an order received by a client may be executed on its OTF, as described above (Questions and Answers on MiFID II and MiFIR investor protection and intermediaries topics, ESMA35-43-349, Question 13 updated on 4 April 2017).
Moreover, in the Answer to Question 19 in the Questions and Answers on MiFID II and MiFIR market structures topics, ESMA70-872942901-38 ESMA clarified on 3 October 2017 the issue how the OTF best execution obligations apply when third-party brokers are clients of the OTF or when these brokers provide Direct Electronic Access (DEA) (Article 4(1)(41) of MiFID II).
According to ESMA, when an investment firm or a market operator operating an OTF receives orders or indications of interest from a broker acting on behalf of its own clients, the operator of the OTF should be implementing its own best execution policy when executing the order from the broker orders as it owes its user clients (the broker) the duty of best execution.
The broker should determine that the OTF it selects allows it to comply with its best execution obligations towards its own clients.
To that end, the broker should conduct a performance assessment of the OTF including how discretion is exercised.
In the specific case of DEA to an OTF, the DEA order is entered in the OTF client’s name (the broker) and the OTF operator should execute the DEA order as it would for any OTF client order.
Alternatively, the operator of the OTF may decide not to permit DEA to its system.
ESMA also noted that a DEA order could be considered as a client specific instruction to the broker providing the DEA arrangement to its clients.
OTF and systematic internaliser interrelations
The operation of an OTF and systematic internalisation within the same legal entity is not allowed under MiFID II.
Systematic internaliser (SI) and an OTF mustn't be operated by the same legal entity even when they do not trade the same instruments or class of instruments (e.g. an SI in equities and an OTF in derivatives).
ESMA on 3 April 2017 expressed the view that the very general wording of Article 20(4) of MiFID II introduces a blanket prohibition of the combination of the OTF and SI activities by the same legal entity across asset classes and instruments.
On the ground of the above rule the ambiguity, moreover, arouse whether shared resources between separate entities are legally possible, where an investment firm that is an SI set up a separate legal entity to operate an OTF (or vice-versa).
According to ESMA, having two separate legal entities operating the OTF and the SI aims at ensuring that each venue is operated to the sole benefit of its respective clients and is not influenced in any way by the activity undertaken by the other venue.
To that end, ESMA is of the view that the two legal entities respectively operating the SI and the OTF should have arrangements in place that prevent information sharing on each other’s relevant activities regarding the operation of the OTF and the SI.
This would include for instance having distinct management and operational teams and physical separation of activities.
Similarly, whereas some elements of the IT infrastructure could be shared, execution systems would be expected to be segregated and safeguards in place to ensure that there is no information leakage across the SI and the OTF activities.
Outsourcing from one legal entity to the other should only be considered where the arrangements in place meet a similar test.
The above is without prejudice to the MiFID II provisions on identification and management of conflicts of interest to be met by each of the two investment firms.
Another aspect is that Article 20(4) of MiFID II limits the circumstances under which an OTF may connect with other liquidity pools by prohibiting orders placed in an OTF to interact with quotes or orders in a SI or with orders in other OTFs.
According to ESMA (Q&As of 03.04.2017), interaction would occur when buying and selling interests would comingle in the same liquidity pool.
Accordingly, an SI quote may not be placed on an OTF. Nor can an order originating from another OTF.
ESMA highlights that a trading interest in an OTF may not be executed against an opposite order or quote on another execution venue.
For a transaction to take place, the two opposite trading interests must be placed with the same execution venue.
However, this does not prevent the investment firm or the market operator operating an OTF from retracting the order from the OTF and sending it to another OTF, to an SI, an MTF or a regulated market, where consistent with the investment firm’s or the market operator’s execution policy and exercise of discretion.
Execution of client orders in an OTF against the proprietary capital of the investment firm or a market operator
Investment firm or a market operator operating an OTF is not granted the possibility to execute client orders in an OTF against the proprietary capital of the investment firm or market operator operating the OTF or from any entity that is part of the same corporate group and/or legal person as the investment firm and/or market operator.
Investment firm or market operator operating an OTF is, however, allowed to engage in matched principal trading in bonds, structured finance products, emission allowances and certain derivatives (which ones presumably be specified by Member States implementing the Directive) provided the following conditions are met:
1. the above financial instruments are not subject to the clearing obligation under EMIR,
2. the client has consented to the process.
Investment firm or market operator operating an OTF is also allowed to engage in dealing on own account other than matched principal trading with regard to sovereign debt instruments, for which there is not a liquid market.
Liquidity for the purposes of this provision should be assessed using the criteria stipulated in the Commission Delegated Regulation (EU) 2017/583 of 14 July 2016 supplementing Regulation (EU) No 600/2014 of the European Parliament and of the Council on markets in financial instruments with regard to regulatory technical standards on transparency requirements for trading venues and investment firms in respect of bonds, structured finance products, emission allowances and derivatives (ESMA's RTS 2).
ESMA has explained that the Regulation at issue sets out how to determine whether a financial instrument has a liquid market.
Although the said Regulation was developed for the sole purpose of further specifying the MiFIR pre-trade and post-trade transparency obligations for trading venues and investment firms, ESMA considers that the methodology and criteria set out therein for assessing whether a sovereign bond has a liquid market are also relevant, and should serve as a reference, for the purpose of Article 20(3) of MiFID II.
It seems that investment firm or market operator engaging in matched principle trading in an OTF must be prepared for strict oversight of the competent authority.
This is to ensure that such trading does not give rise to conflicts of interest between the investment firm or market operator and its clients.
In addition, the investment firm or market operator of an OTF is obliged to provide the competent authority with information explaining its use of matched principal trading.
Market making in an OTF
Investment firms or market operator operating an OTF are allowed to engage another investment firm to carry out market making on an OTF on an independent basis.
An investment firm shall not be deemed to carry out market making on an OTF on an independent basis if it has close links (as defined under Article 4(1)(35) of MiFID II) with the investment firm or market operator operating the OTF.
ESMA recalled that, under Article 18(4) of MiFID II, an investment firm operating an OTF must have arrangements in place to clearly identify and manage the potential adverse consequence for the operation of the OTF and its users of any conflict of interest between the interest of the OTF, the investment firm operating the OTF and the sound functioning of the OTF.
More generally, ESMA highlighted that investment firms must maintain and operate effective organisational and administrative arrangements with a view to taking all reasonable steps to prevent conflicts of interest from adversely affecting the interests of clients.
CCPs as OTFs?
A central counterparty (CCP) defined in Regulation (EU) No 648/2012 (EMIR) as a legal person that interposes itself between the counterparties to the contracts traded on one or more financial markets, becoming the buyer to every seller and the seller to every buyer, do not qualify as the OTF.
Similarly to MTFs, and unlike regulated markets, positions on an OTF count towards EMIR clearing thresholds (contracts concluded in OTFs for EMIR purposes are considered OTC).
OTFs as new platforms appearing with the MiFID II date of entry into force are particularly important for the delineation of the so-called REMIT carve-out, and, hence, also determine in practice the extent of the MiFID II scope.
In the Questions and Answers on MiFID II and MiFIR market structures topics (ESMA70-872942901-38, Question 17 of 3 October 2017) ESMA underlined that a trading platform that is authorised as an OTF based on trading financial instruments can, in addition, offer trading in REMIT carve-out” contracts (i.e. in wholesale energy contracts that must be physically settled), however, an OTF would not be compliant with MiFID II if trading is offered in C(6) REMIT wholesale energy products only.
In the Answer 18 of the same date ESMA also cleared ambiguities regarding the scope of MiFID II/MiFIR provisions applicable to an OTF engaged in trading in REMIT carve-out contracts (for details see REMIT carve-out).
Compliance costs and business' perspectives
On the side of expenses there will be one‑off costs for firms, either existing investment firms or firms new to regulation, who want to run an OTF to vary their permissions or apply to be authorised.
Another driver of compliance costs of existing trading systems will be requirements imposed on an OTF, restrictions on own account trading including.
Given the legal set-up for OTFs has started to apply with the MiFID II entry into force (3 January 2018), before that date there were no practical examples of functioning OTF business ventures.
Some markets positioning themselves for an OTF operated before MiFID II entry into force as the so-called non-MTFs, but there was, generally, the uncertainty before 3 January 2018 as regards the overall extent, to which platforms will register as OTFs.
It was expected that with the introduction of OTFs as a new category of trading venue for non-equity instruments, many new trading venue providers that under MiFID I operated outside a regulated environment (e.g. dark pools, crossing networks, voice brokerage systems) would emerge (Risk Assessment On the temporary exclusion of exchange traded derivatives from Articles 35 and 36 of MiFIR of exchange traded derivatives from Articles 35 and 36 of MiFIR, 04 April 2016, ESMA/2016/461, p. 20).
For calculating compliance costs, some estimates revolved around 25 impacted venues that would be classified as OTFs (Europe Economics, Data Gathering and Cost Analysis on Draft Technical Standards Relating to the Market Abuse Regulation, 6 February 2015, p. 14).
According to Article 19(10) of MiFID II ESMA is required to publish and keep up to date a list of all OTFs on its website.
The register contains data related to the European Union and European Economic Area (EEA) / European Free Trade Association (EFTA) States.
This list contains information on the services an OTF provides (i.e. the asset classes of financial instruments traded on the OTF) and entails the unique code (Market Identifier Code - MIC) established by ESMA in accordance with Article 65(6) identifying the OTF for use in reports in accordance with Articles 6, 10 and 26 of MiFIR.
The register, as visited on 9 January 2018, was populated with data regarding the following OTFs: Aurel BGC, CAPI OTF, CIMD OTF, Kepler Cheuvreaux, Powernext SAS, TSAF OTC.
|Last Updated on Wednesday, 07 February 2018 13:34|