Questions and Answers on MiFID II and MiFIR market structures topics, ESMA70-872942901-38
5 Multilateral and bilateral systems
Question 3 [Last update: 07/07/2017]
Article 18(3) of MiFID II requires that investment firms and market operators operating an MTF or OTF establish, publish and maintain and implement transparent and non-discriminatory rules, based on objective criteria, governing access to its facility. A similar requirement is applied to regulated markets through Article 53(1) of MiFID II. What sort of behaviour or restrictions should be considered as non-objective, or discriminatory?
One of the benefits of more on-venue, pre-trade transparent trading is to broaden access to liquidity for market participants. In order for these benefits to be fully realised, it is important that trading venues do not have restrictive criteria governing their access, which place unreasonable restraints on certain market participants’ access to particular liquidity pools.
In particular, ESMA does not consider the following arrangements to be in compliance with Articles 18(3) and 53(1) of MiFID II. This is not, however, an exhaustive list of arrangements which are non-objective and discriminatory.
a) Trading venues 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), a trading venue should not require all its members or participants to be direct clearing members of a CCP. Trading venues 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, trading venues 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 trading venue might carry out before allowing a member or participant on to their venue. For example, in markets for non-centrally cleared financial instruments trading venues 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 trading venue. 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 trading venue can allow their trading interests to interact. Trading venues will also need to be comfortable that potential participants are meeting the regulatory requirements to be a member of a trading venue 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 a trading venue 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) Trading venues should not require minimum trading activity.
Trading venues should not require minimum trading activity to become a member or participant of a trading venue, as this could restrict the access to the trading venue to large members or participants.
d) Trading venues should not impose restrictions on the number of participants that a participant can interact with.
In a request for quote (RFQ) protocol, a trading venue 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 trading venue. 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.
5.2 Organised Trading Facilities (OTFs)
Question 5 [Last update: 03/04/2017]
What are the characteristics of an OTF? When is the authorisation for the operation of an OTF required?
An OTF is a multilateral system, i.e. “a system or facility in which multiple third-party buying and selling interests in financial instruments are able to interact in the system” (Article 4(1)(19) of MIFID II). The OTF definition supplements this overarching definition by further establishing that only buying and selling interests in bonds, structured finance products, emission allowances and derivatives may interact on an OTF in a way that results in a contract and that the execution of orders must be carried out on a discretionary basis.
In addition, two types of systems operated by an OTF are identified in Article 20(6) of MiFID II: (i) systems that cross client orders (without prejudice to the restrictions placed on matched principal trading) and (ii) systems that arrange transactions in non-equities where the operator of the OTF may facilitate negotiations between clients so as to bring together two or more potentially compatible trading interests in a transaction.
Under Section A(8) of Annex I of MiFID II, the operation of an OTF is an investment activity that requires prior authorisation.
ESMA is of the view that an entity should seek authorisation to operate an OTF where the three following conditions are met: a) trading is conducted on a multilateral basis, b) the trading arrangements in place have the characteristics of a system, and c) the execution of the orders takes place on a discretionary basis through the systems or under the rules of the system.
a) Trading is conducted on a multilateral basis: Interaction with a view to trading in a financial instrument is conducted in such a way that a trading interest in the system can potentially interact with other opposite trading interests. As OTFs are required to “have at least three materially active members or users, each having the opportunity to interact with all the others in respect to price formation” (Article18(7) of MiFID II), an OTF user’s trading interests can potentially interact with those of at least two other users. On OTFs, the interaction of user trading interest can take place in different ways, including through matched-principal trading or market-making, within the limits set out in Article 20(2) and 20(5).
b) The trading arrangements in place have the characteristics of a system: MiFIDII/MiFIR is technology neutral and accommodates a variety of “systems”. A system would be easily identified when embedded in an automated system. This would cover a situation where, for instance, the arrangements in place consist of the automated crossing of client trading interests, subject to the exercise of discretion on an OTF. However, other non-automated systems or repeatable arrangements that achieve a similar outcome as a computerised system, including for instance where a firm would reach out to other clients to find a potential match when receiving an initial buying or selling interest, would also be characterised as a system.
Where a firm would, by coincidence and accidentally, receive matching buying and selling interests, and decide to execute those orders internally, such unpredictable circumstances would not qualify as the operation of a system.
c) The execution of the transaction is taking place on the system or under the rules of the system. The execution of the orders would be considered to be taking place under the rules of the system including where, once the trade price, volume and terms have been agreed through a firm, the counterparties’ names are disclosed, the firm steps away from the transaction and the transaction is then legally formalised between the counterparties outside a trading venue.
If an investment firm arranges a transaction between two clients and the clients decide to formalise the trade on a regulated market or an MTF, the transaction would not be considered as taking place under the rules of the system because a transaction cannot be concluded on more than one venue.
ESMA notes that if an investment firm were to arrange transactions on one system and provide for the execution of the transactions on another system for avoidance purposes, the disconnection between arranging and executing would not waive the obligation for the investment firm operating those systems to seek authorisation as an OTF operator.
ESMA highlights that OTFs are only one of the three categories of multilateral trading systems foreseen by MiFID II. Market participants operating a platform that meets the characteristics of a multilateral trading facility should therefore exercise judgment to assess, based on their business model, whether they need to seek authorisation for the operation of a multilateral trading facility (MTF), an OTF or, potentially of a regulated market. See also Question 5 on the differences between an MTF and an OTF and Questions 14 and 15 on systematic internalisers (SIs) and riskless transactions.
Question 6 [Last update: 03/04/2017]
Does the concept of OTF apply to voice trading and, if yes, when an investment firm executing transactions through voice negotiation should be considered as falling under the definition of OTF?
Yes. 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. 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 conditions set out in Answer 3.
Question 7 [Last update: 03/04/2017]
What distinguishes an OTF from an MTF?
MTFs and OTFs both are multilateral trading systems that can be operated by an investment firm or a market operator. However, compared to MTFs, OTFs have a number of key distinct features:
a) OTFs may only trade in bonds, structured finance products, derivatives and emission allowance (non-equity instruments);
b) 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 SI cannot be operated by the same legal entity;
c) As opposed to regulated markets and MTFs governed by non-discretionary rules, the OTF operator must 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;
d) 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
e) Wholesale energy products that must be physically settled (C6 REMIT) do not qualify as financial instruments when traded on an OTF.
Question 8 [Last update: 03/04/2017]
The operator of an OTF may engage in dealing on own account other than matched-principal trading only with regard to sovereign debt instruments that do not have a liquid market. (Article 20(3) of MiFID II. How should the liquidity of sovereign debt instruments be assessed?
ESMA notes that RTS 2 sets out how to determine whether a financial instrument has a liquid market.
Although RTS 2 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 in RTS 2 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.
Question 9 [Last update: 03/04/2017]
On what basis can a third party investment firm carry out market making on an OTF on an independent basis (cf. Article 20(5) of MiFID II)?
As provided for by Article 20(5) of MiFID II, the operator of the OTF may engage another investment firm to carry out market making on the OTF on an independent basis. The independence test is met when the investment firm carrying out market making has no close links with the operator of the OTF as defined under Article 4(1)(35) of MiFID II.
ESMA recalls 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 highlights 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.
Question 10 [Last update: 03/04/2017]
Can an SI and an OTF be operated by the same legal entity when they do not trade the same instruments or class of instruments (e.g. an SI in equities and an OTF in derivatives)?
No. ESMA is of 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. This blanket prohibition also addresses circumstances under which an investment firm would be operating an OTF and an SI in different asset classes, while being potentially subject to similar conflicts of interests as the ones associated with being an OTF and an SI in the same asset class or instrument. This would be the case, for instance, with an investment firm operating an OTF in equity derivatives while being an SI in the underlying equities.
Question 11 [Last update: 03/04/2017]
Where an investment firm that is an SI has to set up a separate legal entity to operate an OTF (or vice-versa), can those two entities have shared resources?
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.
Question 12 [Last update: 03/04/2017]
Under which conditions can an OTF connect to other liquidity pools such as an SI or another OTF?
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. 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.
Question 13 [Last update: 03/04/2017]
When an investment firm operates an OTF, at which level should the best execution policy be set? At the level of the investment firm, at the level of the OTF or both? Would similar requirements apply to a market operator operating an OTF?
Where an investment firm operates an OTF, ESMA is of the view that 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.
Question 14 [Last update: 03/04/2017]
Does the exercise of any form of discretion mean that a venue is an OTF?
No. Article 20(6) of MiFID II sets out that “the market operator or the investment firm operating an OTF must exercise discretion only in either or both of the following circumstances:
a) When deciding to place or retract an order on the OTF they operate;
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.
For the system that crosses client orders, the investment firm or the market operator operating the OTF may decide if, when, and how much of two or more orders it wants to match within the system. [...] with regards to a system that arranges transactions in non-equities, the investment firm or market operator operating the OTF may facilitate negotiations between clients so as to bring together two or more potentially compatible trading interest in a transaction”.
ESMA understands “execution on a discretionary basis” and “exercise of a discretion” as meaning that, in the circumstances foreseen in Article 20(6), the operator of the OTF has options to consider for the execution of a client’s order and exercises a judgement as to the decision to make and the way forward.
As suggested by Article 20(6), ESMA is of the view that the exercise of discretion can usefully be split into a) order discretion and b) execution discretion.
a) Exercise of discretion at order level
When an investment firm or a market operator receives an order from a client, the “order discretion” refers to the judgement exercised by the OTF operator whether to place the order at all on the OTF, whether to place the whole order or just a portion of it on the OTF, and when to do so. This may be the case for instance where an investment firm would receive a buy order for a 500 lots and would decide to place an order for 200 lots only on the OTF, the remaining 300 lots being executed elsewhere.
Similarly, and as opposed to the operator of an MTF which may not withdraw an order from the MTF at its own initiative unless for fair and orderly market purposes, the operator of the OTF is expected to make a judgement as to whether and when an order should be retracted from the OTF.
This may be the case where, at a given point of time, the OTF operator considers that a more favourable outcome would be obtained by executing the order on another execution venue foreseen in the best execution policy. The OTF operator may also have placed the order on the OTF, sent it to another trading venue simultaneously, subsequently decided to have the order executed on the trading venue and retracted it from the OTF.
The exercise of order discretion would always have to comply with the OTF best execution policy and with client order handling rules. Where clients would be providing a specific instruction to the operator of the OTF, the OTF operator would not be considered as exercising order discretion when complying with that specific instruction.
b) Exercise of discretion at execution level
Under Article 20(6), the exercise of discretion at execution level has to be in compliance with client specific instructions and the best execution policy. ESMA is of the view that the mere implementation of client specific instructions or of best execution obligations would not be the exercise of discretion.
The operator of the OTF is expected to exercise a judgement as to if, when, and how much of two matching orders in the system should be matched. For instance, assuming a buy side order for 500 bonds and an opposite order of 200 bonds have been placed into the OTF, the operator of the OTF would exercise discretion when deciding whether the 500 buy side order should not be matched with the sell side order.
Finally, ESMA highlights that the exercise of discretion, be it “order discretion” or “execution discretion”, should not be just a possibility foreseen in the rules of the OTF and in the best execution policy of the OTF operator. Discretion has to be actually implemented by the operator of the OTF as part of its ordinary course of business and should be a key part of its activities. It is not expected that any quantitative threshold would be set to assess the exercise of discretion. However, as provided for under Article 20(7) of MiFID II, at the time of authorisation or on ad-hoc basis, the market operator or the investment firm operating an OTF should be able to provide to its national competent authority a detailed description of how discretion will be exercised and in particular when an order may be retracted from the OTF and when and how two or more client orders will be matched in the OTF. ESMA also highlights that the OTF operator should be able to explain to its national competent authority the rationale underpinning the exercise of discretion, such as the set of reasons and the logical basis for not matching two opposite buying and selling interests. Random placing, retracting, matching or non-matching of orders on the OTF would not be considered as the exercise of discretion.
Likewise, the exercise of pre-trade controls by the operator of the OTF to ensure fair and orderly trading would not qualify as the exercise of discretion. Post-trade decisions, for example over where transactions are settled, are not relevant either for the purposes of these provisions. Similarly, the decision to enter into a client relationship in compliance with OTF rules on non-discriminatory access does not constitute discretion under Article 20(6).
Question 15 [Last update: 03/04/2017]
Does discretion have to be exercised on an order by order basis?
ESMA is of the view that discretion at order level (see Answer 12) does not have to be exercised 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, ESMA is of the view that, at execution level, discretion whether not to match two potential matching buying and selling interests can only be meaningfully exercised at order level.
Question 16 [Last update: 03/04/2017]
Does a fully automated system exclude the exercise of discretion and should therefore be automatically classified as an MTF?
No. 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.
ESMA is of the view that the 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, ESMA is of the view that 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.
Question 17 [Last update: 03/10/2017]
Can an OTF offer trading in C(6) REMIT wholesale energy products only?
No. Under Article 4(1)(23) of MiFID II, an organised trading facility (OTF) is a multilateral trading system which organises the interaction of multiple third party buying and selling interests in bonds, structured finance products, emission allowances and derivatives, i.e. in financial instruments.
Accordingly, to be authorised as an OTF, a multilateral trading system must offer trading in the financial instruments listed above, without prejudice to the other requirements to be met for such authorisation. However, a trading platform that is authorised as an OTF based on trading financial instruments can, in addition, offer trading in wholesale energy contracts that must be physically settled ( “REMIT carve-out” contracts).
ESMA highlights that the OTF must ensure that genuine trading in financial instruments takes place on the OTF to be authorised, and retain authorisation, as an OTF, with appropriate staff, IT, financial and other resources being devoted to this activity. Trading in financial instruments should not be designed for the sole purpose of obtaining an OTF license and with the end-objective of trading REMIT carve-out contracts almost exclusively.
Question 18 [Last update: 03/10/2017]
When an OTF authorised to trade financial instruments also trades REMIT wholesale energy products, i.e. in non-financial instruments, what are the applicable MiFID II/MiFIR provisions?
MiFID II/MiFIR provisions apply to the operation of an OTF trading financial instruments. Where a person seeks authorisation as an OTF and intends to offer trading in REMIT carve-out contracts as well, a detailed description of the REMIT carve-out trading activity should be included in the authorisation file so that the competent authority can understand and assess the potential impact of REMIT carve-out trading on the investment firm or market operator operating the OTF and on trading in financial instruments. The information to be provided is set out in ITS 19 (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).
Where an investment firm or market operator operating an OTF has been authorised and intends to additionally offer trading in REMIT carve-out products, a detailed description of the REMIT carve-out trading activity should be provided to the competent authority in due course before the start of such trading activities.
The management body of the investment firm (or the market operator) operating the OTF is responsible for defining, approving and overseeing the organisation of the firm or market operator for the provision of investment services and activities, taking into account the nature, scale and complexity of its business and all the requirements the firm has to comply with. ESMA is of the view that the responsibilities of the management body extends to the non-financial instrument trading activity of the OTF as they may have an impact on the investment activities provided by the investment firm (or the market operator). This also applies to the management body’s responsibilities governing the investment firm (or market operator)’s internal policy setting out, among other things, the activities, products and operations offered or provided in accordance with risk tolerance of the firm (or the market operator).
More generally, ESMA highlights that a market operator or an investment firm operating an OTF trading both financial instruments and REMIT carve-out products should identify, prevent or otherwise manage any potential adverse consequences that trading in REMIT carve-out products may have on trading in financial instruments and on its ability to meet its MiFIDII/MiFIR obligations on an on-going basis. Upon request, the operator of the OTF should be able to explain to the competent authority the procedures and arrangements put in place to that effect.
Question 19 [Last update: 03/10/2017]
How do the OTF best execution obligations apply when third-party brokers are clients of the OTF or when these brokers provide Direct Electronic Access (DEA) (see Article 4(1)(41) of MiFID II)?
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 notes that a DEA order could be considered as a client specific instruction to the broker providing the DEA arrangement to its clients.