MiFID II: Europe’s silent attack on automated FX trading and the unfair bank platform advantage over liquidity takers

If all exchanges, MTFs, OTFs, a-book and b-book brokerages have to adhere to MiFID II’s price and execution rulings including the publication of their entire client bases and real time trade data, why are the Tier 1 banks that are currently creating a liquidity credit crunch allowed to choose how and when they execute trades, and operate anonymous and un-transparent order flow methods?

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The forthcoming MiFID II regulatory framework that is set to span the entirety of the European Union’s member states has generated a wave of regulatory technology requirements within electronic trading companies from London to Limassol.

Regulatory technology, or, as it has become known, regtech, is a burgeoning sub-sector of the electronic financial derivatives industry that has become very much a cornerstone of corporate governance since in the lengthy advent of MiFID II, which is scheduled to be fully implemented by the European Securities and Markets Authority in January 2018.

During a recent symposium in Limassol, Cyprus, held by post-trade execution, operation, processing and reporting company Point Nine, a morning discussion attended by FinanceFeeds which included senior executives of FX brokerages as well as industry-specific attorneys and management consultants drew a conclusion that MiFID II’s requirements strictly categorize price quality, speed of execution, likelihood of execution, settlement size, information relating to execution venue and financial instrument traded.

The amount and nature of the reported data must be published and be made available for public viewing on a quarterly basis, hence it will be quite apparent as to which venue is conducting what type of order flow.

The specific categories which companies are designated under MiFID II include not only b-book non-bank FX brokerages (systematic internalizers) and OTFs and MTFs, but also Regulated Marketplaces (RMs), which are derivatives exchanges.

It may well be fair to say that Europe is far less populous with proprietary and algorithmic trading companies than North America, Chicago and New York being home to a substantial number of ‘prop shops’, however there is far more to the execution rulings proposed by MiFID II than simply attempting to stem the systemic advantage held by proprietary trading companies due to their superior algorithms that automatically trade on a large scale and give a perceived advantage over others.

MiFID II seeks to take what is now dubbed ‘RegAT’, an acronym for Regulation Automated Trading, which under MiFID II means modifications to trading methods, market access, client services, technology, people and the markets themselves.

It may not appear very significant to retail FX brokerages or their institutional liquidity providers in markets outside China, where most traders are operating their own accounts manually, or are using a copy trading system which also does not qualify as an algorithmic trading method.

A closer examination of MiFID II’s intrinsic rulings on algorithmic trading highlights several very important factors which may lead to single dealer platforms at banks – the very platforms which provide Tier 1 liquidity to prime of prime brokerages – being subject to changes with regard to algorithmic trading, a practice that is extremely common among the interbank dealers.

This in itself is enough to warrant significant interest from the OTC derivatives sector.

A firm engaging in algorithmic trading or providing direct electronic access must notify its Member State competent authority and that of the trading venue of which it is a member.

The firm’s home Member State competent authority may, at any time, require the firm to provide details of the systems and controls it has in place and, in relation to algorithmic trading, a description of the nature of its strategies.

This information can be shared with the Member State competent authority of the trading venue. The firm must also keep records to enable the Member State competent authority to monitor its compliance with these requirements.

On one hand, this makes sense and appears to be an evolution of current rulings, however it will be of interest to see how this affects FX dark pools, many of the larger examples of which are owned and operated via interbank single dealer platforms, such as the UBS MTF, which is a non-displayed multilateral trading facility operated by the bank that provides anonymous diverse liquidity to members and has been the bugbear of the US regulatory authorities – notably the CFTC – recently.

Indeed, interbank dealers use such dark liquidity for many purposes, including to gain an advantageous position at the top of the liquidity distribution spectrum to diversify their risk and provision, and to strengthen their position. MiFID II’s position on this will be something to consider when it is in place.

RegAT goes a step further with ‘non-member traders’ – i.e. those performing automated trading on the behalf of clients.

Each non-member trader will be subject to risk controls, regulator registration and testing regimes. If those are not adhered to, trading futures algorithmically will not be permitted. This should be a matter of concern for firms relying heavily on introducing brokers that provide portfolio management services, and also should be of interest to copy trading and social trading companies.

With regard to automated trading, regulators believe that algorithmic trading has the potential to cause rapid and significant market distortion. Specifically there are concerns over the high order cancellation rate, increased risk of overloading systems, increased volatility, the ability of algorithmic traders to withdraw liquidity at any time and insufficient supervision by competent authorities.

This goes hand in hand with MiFID II’s position on creating greater liquidity, lowering costs for investors, increased volume, narrower spreads, reduced short term volatility and better price formation and execution of orders.

All of this may well be welcomed by the OTC industry, whose reliance on increasingly more reluctant and untransparent eFX divisions of Tier 1 banks to provide access to credit may well be easier to assess as all transactions, prices and order flow details will be made public information across all venues, however the ability for banks to continue to operate ‘last look’ methodology when executing orders at their own FX platforms may be viewed by many as even more insidious than it already is.

If MiFID II requires all organized trading facilities (OTFs), multilateral trading facilities (MTFs) and trading venues (RMs) to publish full trade information on a real time basis will be mandatory, thus causing firms to have to make their most valuable asset – their hard earned client base – visible to every individual or entity that looks at publicly available trade reports, along with how prices were calculated, how trades were executed, and whether they were executed correctly with no waiting to see if the outcome can benefit the broker rather than the client, then why are banks allowed to conduct last look practices?

Last look execution is not regarded with fondness by most OTC market participants.

EBS, the electronic brokerage division of British interdealer broker ICAP, having gone a stage further in February last year by implementing a policy which aimed to abolish the need for last look execution altogether with the launch of the firm’s new EBS Live Ultra price feed which streams real-time market data from EBS Live which is operated by the firms EBS Broker Tec division, last look is alive and well at bank level.

Whilst not a mandatory implementation, EBS stated at the time that it took this action as a result of feedback and demand from corporate clients.

This is indeed all very well, however major banks are creating a double edged sword with regard to execution and provision of Tier 1 liquidity.

On one hand, banks have become extremely cautious with regard to extending credit to prime brokerages in order to provide aggregated liquidity feeds to the OTC derivatives market, Citigroup, the largest FX dealer by volume in the world with over 16% of all global FX order flow being handled from its Canary Wharf office, stated this year that it predicts a 56% potential default rate from OTC derivatives participants on counterparty credit, yet on the other hand, the very same banks are picking and choosing which trades to exit if the market moves against them, to the detriment of brokerages and liquidity providers globally.

The Financial Conduct Authority (FCA) which presides over the world’s largest institutional and retail center – London – last year conucted its own review into the supervision and transparency of some markets, including the FX market. The FCA’s Fair and Effective Markets Review, or FEMR, specifically asked asset managers and other bank clients about their views on last look.

While some foreign-exchange platforms already don’t permit last look, it is still allowed on some large venues, including the aforementioned BATS-owned Hotspot FX, as well as FXall, owned by Thomson Reuters. Hotspot and FXall account for about 25% of clients’ electronic FX trading, according to financial services industry consultants Greenwich Associates.

Barclays is one of the world’s most prominent proponents of the last look execution procedure, its BARX platform which provides FX liquidity by streaming indicative prices on an in house and third party platform basis.

Barclays’ corporate standpoint on the reasons why it uses last look methodology is that being one of the world’s largest interbank FX dealers, it does not generally seek to reject trade requests. However, electronic spot FX market-making is a highly competitive industry and for the reasons set out above it necessarily exposes the liquidity provider to the risk of trading on incorrect pricing.

Barclays maintains that last look functionality is used to protect against these risks and allows liquidity providers to show considerably tighter electronically streamed prices than they otherwise could – something that the bank considers beneficial to every user of electronic FX trading platforms.

Beneficial to who? That is the question.

In January this year, the Foreign Exchange Professionals Association (FXPA), held a webinar on examining the implications of last look for the FX markets.

Attorneys with Steptoe & Johnson on the ‘last look’ webinar, advised market makers to be more transparent about how their last look systems operate.

“Regulators take a very dim view of institutional practices that emphasize a lack of transparency and that encourage employees to give either misdirection or less than complete information to counterparties when direct questions are asked,” said Mike Miller, litigation partner at Steptoe & Johnson, who spoke during the webinar.

In one high-profile case, a global bank used its spot FX trading platform to reject unprofitable trades. When customers asked why the trades were rejected, the bank reportedly gave “vague or misleading answers,” said Steptoe partner Jason Weinstein who analyzed the case during the webinar.

After a regulatory settlement, the bank posted detailed disclosures on its web site and also paid a steep fine, setting a precedent that could impact other banks, brokers and market-making firms.

FinanceFeeds has spoken at length with a number of senior executives within the institutional and prime brokerage sector recently, many of which have openly stated that banks do not like firms that offer ‘no last look’ execution, despite the regulatory and government derision aimed at the practice.

The very same BARX platform operates the BARX Gator system, which was unveiled in 2013, and works alongside the existing BARX FX single dealer platform, giving clients the choice of when to pass execution risk onto Barclays and when to take more themselves. Clients can then manage post-trade workflows to combine, split and roll-out completed orders.

Furthermore, there is complete anonymity for the client as counterparties on external markets only see the Barclays name. Barclays manages all the technology aspects for clients, such as the maintenance of multiple connections to multiple venues, without passing on fixed costs. Whilst this is just one example, it is not uncommon for interbank dealers with large FX market share by volume to operate similarly.

Most certainly it appears that one rule applies for one side of the execution chain and another for the priveleged market makers at the top.

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