Thursday, March 3rd, 2016
by GEORGE BOLLENBACHER
In an earlier article I took a look at an unintended, but very real, conflict between two components of the EU market rule catharsis known as MiFID II/MiFIR – best execution vs pre-trade transparency. Now it’s time to look into another conflict, between best ex and the trading obligation. Let’s start with the rules themselves.
Article 27 of MiFID II requires firms to “take all sufficient steps to obtain, when executing orders, the best possible result for their clients taking into account price, costs, speed, likelihood of execution and settlement, size, nature or any other consideration relevant to the execution of the order.” One thing to recognize right away is that this applies to the execution of orders. If a dealer makes a market to a customer, and the customer executes off that market, there is no order involved. The second factor is that the rule is triggered by where the customer is domiciled.
On the other hand, Article 23 of MiFIR says that firms shall “ensure the trades it undertakes in shares admitted to trading on a regulated market or traded on a trading venue shall take place on a regulated market, MTF or systematic internaliser, or a third-country trading venue assessed as equivalent.” And Article 28 says, in a very convoluted way, that trades in EU listed derivatives between two FCs or an FC and an NFC+ must be traded on a venue, which definition includes OTFs and SIs. Collectively, these requirements are generally called the “trading obligation.”
Next we have to determine which of the firms acting as a broker are subject to MiFID/MiFIR. If the firm has no footprint in the EU, it is nominally not subject to these rules, but then ESMA and other EU regulators will take the position that it cannot do business with any EU customers. Whether a non-EU firm chooses to abide by those wishes is an important decision.
Finally, we need to know where the customer and the instrument are domiciled. Customers domiciled in the EU trigger the best ex requirement but not trading, and instruments traded in the EU trigger the trading obligation but not best ex. Everyone clear on all that? Good.
Where they conflict
The most obvious possible conflict between best ex and trading is where a stock is dually listed, and the venue outside the EU isn’t assessed as equivalent by ESMA, but has the best price. If a non-EU customer gives a broker subject to these rules a market order in this stock, under EU rules the firm must execute it on the EU venue, no matter where the best price is. However, if an EU customer gives the same order, the broker must violate either the best ex or the trading obligation.
The various rules and RTSs don’t offer any guidance on how to resolve this conflict. Some people have tried to read between the lines of the rules, saying that the trading obligation language is more explicit than the best ex language, so trading obligation trumps best ex. Others say that their obligation to the customer trumps any rule about where you can trade. Either way, we’ve clearly found a rock and a hard place for the firm. Which would you rather deal with: an angry customer or an angry regulator?
Another possible conflict is a firm doing a trade in a derivative listed in the EU with an NFC+ counterparty, where the best price the firm will pay is available in an OTC market outside the EU as well as on the EU venue. If the NFC+ customer is not a member of the trading venue, then the mandated venue execution is worse by having to pay a commission to trade with the same party it could otherwise trade with net.
Any Solutions?
When we combine this conundrum with a few others, and factor in both the very intrusive transaction reporting requirements and some restrictions on the use of algos, we start to see some distinct benefits to setting up a business completely outside the EU and making yourself available to trade with both EU and non-EU customers. Of course, that strategy carries lots of risks, mostly around how the EU would respond. If the implementation of this European mishmash of regulations prompts not only a Brexit, but a substantial grey market, both in EU instruments, and for EU customers, we should expect ESMA and the EC to do something about it.
One obvious avenue is pressuring market regulators outside the EU to enforce the EU rules locally. In the best market traditions, that would probably prompt a “What have you done for me lately?” response. So a quid-pro-quo solution might emerge. I’ll enforce your rules on my citizens and markets if you enforce mine on yours. It’s happened before.
Another alternative is 1) developing internal consistency within the EU rules and 2) global coordination of market regulation. How likely do you think that is?
