European markets regulators are examining a potential loophole in share-trading rules, which they fear promotes lightly regulated, private networks rather than placing curbs on trade away from public exchanges.
Concern is mounting that the rules, which take effect from next January, could be exploited by some banks and high-frequency traders (HTF), to sidestep policymakers’ determination to make share trading more transparent.
In an effort to improve trading transparency, the forthcoming Mifid II legislation will recognise investment firms that match customers’ orders via their own trading desks as “systematic internalisers”. This term refers to investment firms that transact shares for themselves and not for their clients.
While there are fewer than 10 systematic internalisers in Europe, their ranks are set to expand, bolstered by banks and also HFT firms, with the risk that more share trading ultimately occurs in private venues and away from public exchanges.
“We expect there will be significantly more [banks] getting ready for Mifid II,” says Mark Hemsley, chief executive of Bats Europe, the region’s largest equity exchange. “But it may also be attractive to other parts of the market.’’
The European Securities and Markets Authority (Esma), the pan-European markets regulator, has expressed concern that some large high-frequency traders could also apply to be a systematic internaliser.
Recently the regulator wrote to Brussels with the blunt warning that the rules could be “circumvented” by banks offering to trade with only a favoured few clients, especially HFT companies. Members of the network could support the arrangements with agreements to supply trading flow, reinforcing the trend of so-called dark pool transactions.
Already, about half of the European market is traded away from order books run by exchanges, according to data from trading technology company Fidessa, although the number is clouded by exchanges’ differing definitions.
That scale of equity trading away from public exchanges via dark pools or through banks’ own internal trading desks, has prompted regulators to push against that growing trend. But their efforts are potentially seen as backfiring and reducing the quality of public markets, hurting investors.
Rainer Riess, secretary-general of Fese, the European exchanges association, says: “Exchanges, politicians and regulators see it as a potential loophole and investors will be the ones that get hurt by it.’’
Others argue the concerns are overblown. Privately, banks planning to become systematic internalisers call the allegations unfounded. The systematic internaliser status allows exemptions from rules on minimum quoting and trading increments — or tick sizes — that encompass exchanges. Trades only have to be reported within a minute of a transaction — representing an age in a world where trades are conducted in milliseconds. Quotes for certain large orders can also remain private.
Banks point out that UK regulators take a dim view of delays in trade reporting. Furthermore, the rules would mean proprietary high-frequency traders would potentially be putting more capital at risk for longer.
Even so, the prospect of high-speed traders becoming systematic internalisers has alarmed some. “People have got a long way in how they’re going to make it work,” says one exchange executive who declined to be identified.
The attraction for an HFT firm of becoming a systematic internaliser reflects the ability in theory that they would be able to execute transactions with selected clients in private. Such trading away from public exposure means share prices would remain relatively stable and allow the HFT firm to hedge the position on an exchange before the trade is made public.
That could be lucrative with banks and traders trading their customers’ orders while avoiding the costs of trading on an exchange.
However, not all HFT firms are looking to become systematic internalisers and, moreover, they are keen for regulators to close the loophole.
“Not only could these developments siphon considerable volume off the lit markets, all of the issues will deteriorate the quality of liquidity remaining on lit markets,” says an executive at one US proprietary trader.
Esma has asked Brussels if the rules need to be rewritten via a fast-track legislative process known as a delegated act. There are some indications of a consensus building among various branches of the European legislature.
Kay Swinburne, an influential British MEP in economic affairs, says Brussels is looking at the issue in depth. “If we find that [market participants are] going to be using the SI [systematic internaliser] regime disproportionately, then that would be completely failing to meet the objective of more transparency in the equity market,” she says.
But changing the rules takes time and regulators have precious little of it. Lawyers say the simplest solution is clarification of the Mifid II rules, either by the commission or by the question and answer documents on technical issues sent out regularly by Esma.
“Clarity this way . . . would be welcomed not only to avoid uncertainty this close to the Mifid II go-live date but also any unintended consequences if there was a political compromise to the main Mifid text,” says Sam Tyfield, a lawyer at Vedder Price in London.