We recently provided an overview of the key capital market reforms of MiFID II on the OTC markets. With some accompanying suggestions to help begin the planning process of how to best structure business activities around the regulation. Following on this commentary, we provide some insights on how an online auction based trading system can help satisfy the requirements of global financial regulation. First a high level recap of MiFID II… The EU law whose central purpose is to legislate how the European single market for financial instruments operates. It is primarily concerned with harmonizing the regulation governing the trading of financial instruments across all EU member states. In doing so it aims to promote competition for financial services and consumer protection in investment services. It is part of a jigsaw puzzle of EU financial regulation that includes: European Market Infrastructure Regulation (EMIR), Capital Requirement Directive (CRD), Market Abuse Directive (MAD), Regulation on Wholesale Energy Market Integrity and Transparency (REMIT) and yet to be drafted regulation on financial benchmarks used for settling derivatives.
Why will we see increased electronification?
There are numerous initiatives in the world of exchanges right now. We see them moving quickly to adhere to, and where possible take advantage of legislative changes that affect how (OTC) markets operate in terms of both mandatory clearing and transparency. This thinking is in-line with the proposed changes that MiFID II will bring, including:
- Organisational requirements for licensed investment firms and trading venues. For example, what is required in terms of corporate governance, record-keeping, IT systems and controls;
- Fair treatment of clients by investment firms – how to act in the most appropriate way in the best interests of clients and be able to demonstrate this to local regulators;
- Demonstrating that orders by investment firms acting on behalf of clients, are optimally executed for the client’s benefit;
- Specific requirements in the information that investment firms must disclose to their clients;
- Transparency, data consolidation and reporting – e.g. pre- and post- trade requirements for the collation and publication of trade data, official trade reporting and the maintenance of historical records;
- The definition of a trading venue and their classification into one of three types: Regulated Markets (RMs), Managed Trading Facility (MTF) and Organised Trading Facility (OTF) – all of which will have to conform to specific regulations if they wish to operate within the EU; and
- Specific treatment for commodity derivatives – e.g. limits on the net positions that can be held and the resulting reporting and monitoring burden that will be required to enforce this.
Satisfying these requirements, in particular those for monitoring and reporting, necessitates a significant investment in IT infrastructure, external market data feeds, and will result in a huge flow of electronic information throughout the financial system as a whole. This is complicated further by a regulatory landscape that is continually evolving and segregated by jurisdiction (e.g. MiFID II only applies within the EU and the Dodd Frank act only within the USA).
Satisfying global financial regulation requirements with an auction based trading system
An auction based electronic trading system would allow for the creation of far better liquidity in derivatives markets by providing access to a price discovery mechanism that is optimal for non-standard and hard-to-value financial instruments (such as bespoke derivative contracts or highly specific physical commodities). For example, bids (and offers) can be truthfully communicated to the exchange (the auctioneer) in private, with full confidence that the final trade will go to the bidder who values it the most. When creating a new marketplace or moving a marketplace online it is crucial that marketplace design is thought through end-to-end. In addition to a suitable trading mechanism, a market must possess four key attributes for success. Adapted from the Nobel Memorial Prize in Economic Sciences (2012) Alvin E Roth; a market must be:
- Thick (enough potential transactions at one time);
- Uncongested (enough time for offers to be made, accepted, rejected);
- Secure (secure to participate and to reveal relevant preferences); and
- Easy to use (low friction and clarity of pricing).
Achieving a marketplace with these attributes requires an understanding of the market’s participants combined with technology that is configured to meet their requirements. For example, if a market is ‘small’ and trades infrequently, then in the interests of optimal pricing (e.g. based on accurate estimation of supply and demand), liquidity is better concentrated around a few specific auction events – as opposed to providing a real-time trading facility (e.g. a continuous double auction or ‘order book’). Similarly, if a market is ‘large’ and trades have 100s of potential attributes, then surfacing information about potential trading opportunities, and getting the right information to the right counterparties at the right time, will be necessary to maintaining an uncongested market that is easy to use. There are real benefits of moving a marketplace onto an online auction based trading system such as Perfect Exchange, as it will:
- Provide a digital exchange for industries/markets lacking a universal marketplace;
- Digitise the existing trading process making it more efficient and transparent;
- Easily integrate with third party systems;
- Provide a low total cost of ownership and obvious quick return on investment;
- Help sellers and buyers locate each other and achieve the correct price for their goods or services;
- Achieve better prices for both buyers and sellers – more reliable price discovery in-turn stimulates liquidity;
- Give real-time trade monitoring and analytical services with the Perfect Insight platform;
- Optimize and automate the settlement process;
- Reduce counterparty risk by integrating clearing services; and
- Provide an auditable price discovery process – it is easy to prove that a trade was executed fairly on an economically rational basis.
Stay tuned for an upcoming white paper where we provide an in-depth look at how MiFID II is driving interest in exchange-based trading. With some commentary on how we see our approach and technologies as key to helping our clients satisfy specific MiFID II requirements while maintaining a strategic adherence to more general global regulatory themes.