What constitutes a trading venue? Which kinds of firms should be regulated as trading venues? The answers to those questions are the subject of much heated debate in Europe, and the review of the Markets in Financial Instruments Directive (Mifid II) could throw fuel on that fire.

Market observers say the European regulator’s broad definition of which companies must register as organized trading facilities (OTFs) or multilateral trading facilities (MTFs) pulls into the scope of the regulation hitherto unregulated software providers.

A broad definition of a trading venue could capture a multitude of vendors, including chat applications, front-office systems, systematic internalizers, and connectivity providers, says Stephane Malrait, head of market structure and innovation for financial markets at ING Bank.

“Your chat system is a software that lets you connect to 10 or more banks electronically and negotiate transactions and books electronically. So where do you put the limit?” Malrait asks.

The European Commission (EC) is engaged in a wide-ranging review of Mifid II that began in early 2020. As part of this exercise, the European Securities and Markets Authority (Esma) consults with the market, then produces reports on various aspects of Mifid II. The EC then presents those reports to lawmakers, and they decide if changes should be made into the law.

One aspect of Mifid II that Esma has consulted on is the definition of what makes a firm an OTF or MTF. Esma’s final report on the functioning of trading venues under Mifid II, published in March after the consultation period, includes some ideas about how the definition needs to be adjusted.

Mifid II established the concept of OTFs to extend the definition of trading venue to facilities offering trading in non-equities instruments, bringing transparency in traditionally over-the-counter (OTC) asset classes. Registered OTFs include Tradeweb and ICAP Securities OTF. MTFs existed before that—they were introduced in the first iteration of Mifid—but were essentially the result of the expansion of the definition of trading venue to include facilities that weren’t traditional exchanges.

Esma says in its final report that it understands an OTF or MTF to be “any system that allows third-party trading interests in financial systems to interact, including information exchange between parties on essential terms of a transaction (price, quantity) with a view to dealing in those financial instruments.”

That is enough to require authorization as a trading venue, it says. And the information exchanged does not need to lead to a contractual agreement within the system between parties for the interaction to occur, it adds.

By comparison, under Mifid II, MTFs and OTFs are deemed “multilateral systems where trading interests can interact in the system in a way that results in a contract.”

This is an area of ambiguity that Esma’s critics say needs resolving.

Heated debate

The issue generally has touched on a longer-running debate over which kinds of firms should be regulated as MTFs and OTFs.

Fixed-income venues like Bloomberg and Tradeweb have lobbied the EC and Esma via trade associations like the Electronic Debt Markets Association (Edma) to regulate a cohort of tech vendors—including some providers of workflow tools, price aggregators, and even order and execution management systems (OEMSs)—which these venues say are mimicking trading venues and operating without their relevant licenses. The venues contend that these vendors’ activities are invading their territory, but are not being regulated, and thus creates an uneven playing field.

Jennifer Keser, head of regulation and market structure at Tradeweb, says that rather than roping in multiple vendors that support one or two periphery services in the trading lifecycle, the definition should apply to firms that run all or several services that lead to the multilateral) interaction of buying and selling interest and ultimate execution of a trade.

“If I am a technology provider that only does one particular thing, perhaps, I offer the connectivity, or I allow the pipes for the buyers and sellers to meet and to exchange their buying and selling interests. But [if] I’m in no way part of the execution, then I would say that it’s probably a bit heavy-handed to have that type of entity go through the same process as we do because they’re not part of every action in a chain of events,” she says.

Bloomberg declined to comment for this story, but in its comment letter to Esma, the company had this to say: “We welcome Esma highlighting concerns about firms operating de-facto multilateral systems without being authorized as trading venues, and hence being subject to the relevant MiFID provisions. A key objective of Mifid was to increase transparency, but there is an enforcement/perimeter issue where software providers are operating systems where multiple third-party interests interact that result in off-venue transactions.”

The fixed-income venues believe that the vendors encroaching on their turf include Neptune, a provider of pre-trade bond data; Symphony Sparc, an interest rate and cross-currency swaps workflow platform; Virtu Financial’s multi-asset request-for-quote (RFQ) hub; OTCX, an RFQ platform for derivatives; and GMLX, an electronic securities financing platform.

In the opposite corner of the debate are these tech providers, who say their businesses do not meet the criteria to be considered regulated venues under Mifid II, and they, therefore, don’t have to register as OTFs or MTFs in Europe. 

“We always want to work with regulators, so we want to have a cooperative approach, and make sure that we’re part of the dialogue with regulators, so we’ll see what approach regulators here in European and the UK take going forward,” says Corinna Mitchell, general counsel at Symphony.

Separately in the US, in April, WatersTechnology reported that Symphony had suspended its Sparc business pending registration talks with US markets regulator the Commodity Futures Trading Commission to obtain a license to become a swaps execution facility (Sef). The CFTC ordered Symphony on September 29 to pay a $100,000 penalty for operating Sparc without registering as a regulated trading venue. Prior to the CFTC order, Symphony’s Mitchell could not comment on the registration talks for legal reasons.

Neptune COO Byron Cooper-Fogarty says there was speculation that Neptune would look to build out execution services, and that might be what sparked the concerns of the incumbent venues. Rather, he says, Neptune is partnering with other firms that provide execution services such as its integration with Tora, a fixed-income OEMS provider, in December 2020.

“At no stage were we looking to provide direct execution ourselves. It would be through partners that are or would be looking to regulated entities, and our part of that is providing the data. I don’t see that as a regulated activity, certainly not the way the regulation is written at the moment,” Cooper-Fogarty says.

Neptune pulls in data from around 30 dealers and streams it to more than 70 buy-side firms.

Cooper-Fogarty says the firm has no interest in becoming a regulated trading venue but would evaluate any new responsibilities if the regulatory frameworks are extended to include vendors like Neptune.

“It’s all good saying it’s regulated activity, but there are certain obligations that come with that,” he says. “So, we’d need to see what those additional obligations are.”

A spokesperson for GLMX says that the vendor “completes extensive, recurring regulatory reviews in all geographies in which it does business and is fully confident that its structure meets all applicable regulatory requirements.” 

Similarly, OTCX co-founder and COO Paul Stones say the provider “always makes sure that our service meets all regulatory obligations within the different jurisdictions we operate in and carefully monitors any evolution of such frameworks to remain compliant.”

Virtu Financial was unavailable to comment for this article. 

A big tent of vendors

It’s not just this particular vendor community—the ones that seem like immediate threats to the venues—that would be drawn into trading venue status by an expanded definition. A small universe of providers that even the incumbent venues don’t believe should be regulated could be unintentionally affected, even telecommunications providers, Malrait says.

Whether these companies are regulated should be about how they behave, not the tech they offer, he adds.

“I don’t think you can put those rules on the basis of the technology you develop because technologies look very similar. It’s more about how you run your activity,” Malrait says.

One source with close ties to fixed-income trading venues says the Esma guidance extends further than what the venues themselves were lobbying for. In other words, venues argue that the current Mifid II wording of “multilateral systems that interact” and “result in a contract” should be kept and enforced, rather than follow Esma’s interpretation, which required a lower threshold to become a trading venue, including “any system that allows third-party trading interests in financial systems to interact.” 

“When we engaged with them [Esma] their view was that it doesn’t have to include multilateral execution, even multilateral interaction also needs a venue license. If somebody interacts over a system, and no trade results, that is still a multilateral activity and needs to be regulated as a venue. We were arguing the point below that, so those that are interacting and doing transactional business,” the executive says. By the same token, the executive adds, that the trading venues were also relieved that Esma’s guidance more clearly captured the vendors they believed to be operating as unregulated venues. 

Stifling innovation

Whoever they are, vendors that find themselves regulated entities would have some new burdens. It’s no small matter to run a regulated venue: It requires operational support, strong governance measures, and capital.

“We’re not building a retail platform where people are trading football cards,” says Dan Hinxman, head of fixed-income sales for EMEA at TP Icap’s Liquidnet, which operates an MTF in fixed income. “These are financial instruments, and you have to meet all the criteria that have been set forth by all the regulators, which take many more considerations, resources, testing, and all the other pieces that go with it to make sure it’s going to pass those tests.”

Market participants fear that widening the definition of trading venue to their tech providers will drive up costs and stifle innovation in a time when the fixed-income market is starting to understand the benefits of automation. Three asset managers to which WatersTechnology spoke for this article said they fear they will face potential downstream costs if a wider spectrum of tech vendors and trading systems were to become regulated.

“For us, it would be a real concern if OMSs are deemed to be venues because they would have to be regulated as such. They would have to have capital buffers, etc., in the same way, that MTFs do, and that would increase the cost of having that OMS,” says one head of fixed income at a Europe-based asset manager with over $80 billion in assets under management.

Symphony’s Mitchell says being a regulated entity is usually built into the design of a company from the beginning, and is not a natural transition for a tech vendor to make.  

“So it is quite challenging for a company that has been set up to be a nimble, growing, innovative business to then become regulated. It’s certainly possible to do so, but it does require a ground-up change in the way that the company operates and is structured,” she says.

Bilateral vs. multilateral

The debate about what constitutes a trading venue hinges on the distinction between multilateral trading activities, which are regulated, and bilateral, which are not.

Multilateral activities involve multiple buyers and sellers coming together to share trading interests and execute trades. Providers of tech that enable counterparties to interact bilaterally (OEMS or RFQ systems, for example) say they should not be considered multilateral because those systems provide for a multitude of bilateral interactions, not a single multilateral interaction.

“This definition in Mifid II is still not clear: What is bilateral versus multilateral? If you’re on a chat, normally that is a bilateral negotiation or discussion between two people, and even if you structure or electronify that chat, it’s still bilateral,” Malrait says.

The incumbent venues, on the other hand, say a gray area emerges when tech advancement enables more efficient interaction between one buy-side firm and many sell-side firms using the same platform.

“The people who are doing this without a license say it’s not multilateral execution, it’s bilateral execution. What’s the difference there? It’s common sense: You’re introducing people who didn’t previously know each other, and if they are doing regular trading business, that’s multilateral execution,” says the source close to the trading venues.

Regulatory approach

Industry firms are also divided on how regulators should revise the regulatory framework. Some say authorities should enforce the rules as they already exist, while others are more in favor of written clarification and guidance.

The source with close ties to the trading venues says regulators like the Financial Conduct Authority and UK Treasury could use qualitative and quantitative methods to determine which firms are trading venues. This would be a similar approach to how the authorities are looking at the definition of Systematic Internalizers, as part of the recent Wholesale Markets Review, published in July, which also addresses trading venues. In this case, the executive says qualitative methods would mean evaluating the company’s business and conducting individual interviews with the firms.

“I think there’s a common-sense approach, which is what we’re trying to say. Go in and talk to these venues—you’ve got the powers; you’ve got the authority—and if they are introducing counterparties on both sides who didn’t previously know each other, and they end up doing lots of transactional business and that business is not on a trading venue somewhere downstream, then they need to get a trading venue license,” they say.

Neptune’s Cooper-Fogarty agrees that regulators should look at firms on an individual basis rather than have a hard-line definition that could capture a vast group of vendors as the technology evolves. He adds that a black and white definition could create barriers to entry for vendors emerging in the fixed-income market, leaving a small handful of big players to dominate the space. 

“I get in some respects the appeal of the hard-and-fast definition so people can know where they stand before they start, but I think it’s a far more complex and nuanced market than that. So, I think the supervisory case-by-case basis makes more sense because people are going to offer different things to different clients,” he says.

Cooper-Fogarty also says regulators should look at why buy-side and sell-side firms are interested in moving away from electronic trading by leveraging other third-party service providers and trading bilaterally. He attributes this shift to the growing cost of trading on venues like MTFs.

Other participants in the market want to receive more detailed guidance from the regulators on the revised framework. Mitchell says that based on Esma’s guidance, she thinks the authorities will go down the route of offering more clarity, which will need to be adaptable to suit the fast-evolving space.

Andrew Mahoney, managing director at EMS provider FlexTrade, says without more prescriptive detail from regulators, some vendors are left in a frustrating position, trying to clarify to clients why their firm does not fit into the definition of an MTF or OTF.

“Clients might have a number of types of questions and ask us why we aren’t an MTF, and we go through the process of explaining our architecture and explaining why we’re not,” he says. “But it would be much easier if we could reference certain paragraphs within the Esma regulation to say, ‘This is the reason.’”

With additional reporting by Hamad Ali