What makes a trading venue? Recently updated guidance in the UK has focused on the way such venues operate, rather than labels. But does this help to clarify what is in scope and what is not – and how are providers responding to the new rules? Alex Pugh investigates
Execution and order management system (E/OMS) providers risk being fined or even shut down under new rules in force in Europe. Their success hinges on one point: are they really a trading venue? The rules defining this have been set by the European Securities and Markets Authority (ESMA) in the European Union and by the UK’s Financial Conduct Authority (FCA). ESMA published its Final Report on ESMA’s Opinion on the Trading Venue Perimeter on 2 February 2023 while the FCA’s rules came into force on 9 October 2023.
For traders, the effect is twofold. First, costs may rise if their systems must align with regulatory compliance standards. Secondly, and more concerning, a critical system may not be able to function if it is deemed non-compliant.
In July this year the UK followed Europe in issuing guidance on the trading venue perimeter regulation: including its interpretation of what constitutes a trading venue, how the different elements of a multilateral system are defined, and how it might change treatment of specific venues.
Similarly to ESMA in its Final Report of February 2023, the FCA confirmed that the regulatory perimeter would not be changing – but rather, the new information was to clarify what comes into scope.
“To interpret the perimeter, we will continue to focus on the substance of the activity in question, rather than how it is labelled or whether the system operator complies with the requirements applicable to trading venues,” the UK regulator said in a policy statement in July 2023.
Sources have reported different expectations for E/OMS registration as trading venues; while BlackRock Aladdin is not expected to register, TS Imagine is reportedly planning to, or is already in the process of doing so, while Virtu is already registered and Instinet’s Newport comes under the same umbrella as its regulated MTF, BlockMatch.
A problem defined is a problem solved
With trade execution moving more and more towards automation, will obligations on technology providers stifle innovation? Indeed, the interest in streamlining manual workflows and implementing Order Management Systems (OMS) and the wider changes in technology and market structure have enabled new service providers to come to the fore. But regulated trading venues come with higher governance requirements and costs.
The new guidance will concern a number of players: including trading venues, service companies, investment-based crowdfunding firms operating in primary and/or secondary markets, interdealer brokers, broker dealers, portfolio managers, technology firms offering platforms and systems for trading, and firms providing communications systems or bulletin board services.
One crucial question for the buy side is whether EMS will fall under the multilateral definition. The guidance suggests that “multilateral” will be defined as two or more parties (other than the operator) negotiating between themselves within the system. Nor do contracts need to be exchanged – just the point of negotiation is enough for definition, which leaves a wide open window.
The FCA’s four-pronged definition of a multilateral system is a system or facility in which multiple third-party buying and selling trading interests in financial instruments are able to interact in the system, and comprises each of the following main elements: it has the characteristics of a trading system or facility; it comprises multiple third-party buying and selling trading interests; it allows trading interests to interact in the system; and those trading interests are in financial instruments.
A software vendor told Best Execution that to glean some insight into the new guidance, the UK operates on a principal basis, while ESMA is rules-based. “So, if you want to understand where you are, ESMA is the one to look at. The guidance it gives you is in excruciating detail, but you can understand what business expectations are.”
Additionally, “When it comes to risk, if you are the buyer of this software, you might be the operator. If you are the participants of this software, you also might be the operator. You will have to read the ESMA guidelines in order to get comfort that you are not the operator of the system, in particular, if the software vendors are saying, they’re not an MTF, don’t worry about it. There has to be an operator of this system somewhere. That’s the person that really needs to have a long look at the regulation to figure out what their own personal risk is.”
Fragmentation and flexibility
Jesse Forster, head of equity market structure and technology at Coalition Greenwich, told Best Execution that the asset management community expects “significant impact” on how it will need to operate and the costs they will incur.
“The biggest concerns seem to centre around the potential for the rules to be interpreted as requiring asset managers to set up their in-house trading systems as trading venues. This would not only be costly but could make it more difficult to compete with other financial institutions,” Forster said. Fragmentation is another concern, with different managers using different trading systems making price and liquidity discovery more difficult and potentially leading to systemic instability.
Ultimately, the concerns come down to exactly who or which systems this applies to, what the initial and ongoing costs will be, and what impact this will have on market fragmentation. “While the regulators have issued some guidance on interpretation of these rules, it still has not addressed exactly how these rules will be applied. Overall, there doesn’t seem to be much consensus on answers besides a need for continuous flexibility as the process unfolds.”
More broadly, the continuously tightening regulatory and competitive environments are driving a secular trend towards outsourcing trading-related functions to third-party specialty providers, Forster believes. This also includes front-end trading systems, algo tech stacks and mid/back-office operational processes. “Those that are building their own platforms in-house are still often integrating them with related third-party technologies to create hybrid systems.”
Andrew Morgan, president and chief revenue officer at TS Imagine, believes the new guidance will inevitably impact the way firms think about and invest in their systems. “For firms that fall within the scope, there will be a certain level of reporting and additional cost implications in applying for a Multilateral Trading Facility (MTF) licence, for instance.”
For firms that are in a ‘grey area’, unsure whether or not they will be impacted, it may be preferable to move away from activities considered within scope. “For those who may have been in the process of, or thinking about, setting up their own EMS, this new guidance means that unless they wish to become a regulated venue, this isn’t the route for them,” Morgan said.
In-house or buy-in?
The question of whether in-house technology development will suffer from fears around scope goes back to the recurring question for firms of whether to build or buy their technology and systems.
“For those that do decide to apply for an MTF licence, firms may be required to set up an MTF in London, as well as one within the European Union – these additional cost implications will need to be carefully considered,” TS Imagine’s Morgan said.
As a result, firms that have been contemplating the question, and do not have the in-house knowledge and expertise already, may decide to outsource to other providers – delivering time and cost-efficiencies, as well as the regulatory burden falling on the technology provider rather than their own firm.
Either way, with this additional guidance, the aim is to provide additional clarity and remove any ambiguity that firms may previously have been able to take advantage of. “There is a four-part test that firms will need to consider when reviewing their position regarding the perimeter – if they meet the criteria, they will be required to comply,” Morgan added.
With so many regulatory developments, there are implications – both challenges and opportunities – for firms across the board. This guidance may require some firms to rethink their product development pipeline or even their existing offering. For those that don’t want to fall within scope, order management providers may turn off their RFQ capabilities, for example.
On the other hand, this also provides opportunities for providers that already have these capabilities to offer – investors may turn to these providers, who fall within scope, for the technology and expertise they require, without having to develop these in-house at a significantly higher cost.
“Setting up an MTF cannot be done overnight. This is a process that will take some time – firms that had the process underway before October 9th will be in a better position than those that wait, who may find themselves in a grey area with regulators,” Morgan said.
Defined by actions, not labels
According to Jennifer Keser, head of market structure and regulation, Europe and Asia at Tradeweb, the updated scope will solidify firms’ understanding of the trading venue perimeter and provide greater certainty around a firm’s regulatory status.
“The trading venue perimeter is determined by the activity, and not by the label a system gives itself, though there is a specific exemption given to purely bilateral interaction of a proprietary single dealer platform.
“Furthermore, we’ll see a more even playing field as the regulation helps to address firms that are operating multilateral systems without being authorised as a trading venue.
“Any activity that constitutes a multilateral system falls within the new scope. This was already the case pre-guidance, but the updated guidance reaffirms the regulatory understanding of what constitutes a multilateral system. Tradeweb has long believed that a revised definition should apply to platforms and systems on the basis of the services they provide, so this updated scope is a welcome development.”
Whether in-house technology development will suffer from fears around scope depends on the entity, system, or provider that is developing the technology: “There have been concerns that a definition that is too broad may impact innovation and stifle the momentum built around the electronification of markets. However, from our perspective the risk is rather low, as our regulated status never interfered with our culture of collaborative innovation that drives markets forward.”
Keser believes it’s important that the published guidance is implemented in the spirit of the regulators’ intention for the benefit of all market participants. “We’ve always been strong supporters of healthy market structure change that promotes innovation and leads to the development of new technologies, and this updated scope is an example of this.”
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