By Alpay Soytürk, Chief Regulatory Officer at Spectrum Markets

The financial regulation process in the European Union has been subject to consultation and permanent review, with the aim of increasing the flexibility of decision-making processes and improving the overall quality of legislation.

The Markets in Financial Instruments Directive (MiFID II) and its accompanying regulation (MiFIR), is one regulatory framework that has generated some discussion surrounding its controversy prior to and during its implementation, and continues to be subject to intense debate and scrutiny.

The planned changes and amendments to MiFID II / MiFIR would have the most far-reaching consequences for systematic internalisers (SIs), as the potential rules include: the ban on payment for order flow, the removal of the dark pool cap and plans for a European consolidated tape.

Who’s affected?

SIs – firms that “internalise” orders by interposing themselves between clients’ buying and selling interests in order to generate a regular spread income – have been subjected to pre-trade and post-trade minimum transparency requirements.

While this is positive in general, the current rules – which set different quantitative thresholds per instrument, subject to regular adaptions – have proven too complex. According to the draft legislative resolution from the European Parliament, the current rules have led to a significant increase in the number of SIs and added to the regulatory burden of both supervisory authorities and investment firms – disproportionately affecting the smaller ones.

Hence, the legislative draft suggests limiting the SI regime to qualitative criteria at investment firm level, and to those firms that choose to opt-in to this regime. The voluntary option allows firms that wouldn’t otherwise qualify as SIs to assume the reporting obligations of their clients as a service.

What is the double volume cap?

A similarly significant change will be the removal of the so-called double volume cap. MiFID introduced several waivers that allow firms to remain exempt from publishing current bid and offer prices, and the depth of trading interests at those prices for transactions that fall under either of these waivers.

MiFID II also introduced the double volume cap to avoid excess total trading volume being executed on dark pools, thereby not becoming part of the price formation process on lit markets, which discriminates against the retail investor.

It caps the transactions that are allowed to be executed under a reference price waiver and a negotiated transaction waiver at 4% at a venue level and at 8% for all venues throughout the European Union.

The new proposal would limit the use of the thresholds by restricting the transaction size threshold, and the double volume cap would be suspended entirely.

Consolidated tape

A particularly momentous amendment is the EU's plan for a consolidated tape (CT), a central public database providing consolidated pre-trade and post-trade data. Advised by the European Commission, it hopes to establish conditions for a European CT across asset classes, where contributions would become mandatory.

Those exempt from these contributions include small regulated markets, i.e., those that represent less than 1% of the average total daily trading volume in the EU. Another exemption is for venues that don’t significantly contribute to EU market fragmentation, in that they predominantly trade shares for which they are also the venue of primary admission.

Additionally, there will be an opt-in option for the venues that fall under either of these exceptions, then being re-allocated a higher share of revenues of the CT.

Will it benefit the retail investor?

Heralded as cure-alls, it seems appropriate to be a bit less sanguine about a CT’s impact than those who argue it will be to the benefit of the retail investor.

In theory, it would be positive if we can overcome asymmetric information by offering consolidated, up-to-date intelligence on the best prices and execution venues. However, the information on supply and demand for a certain security is of limited value for an investor, unless they can trade against it, because the relevant venue is not accessible to the investor.

It’s a mistake to assume that a CT would be a form of consolidated orderbook. According to the current design plans, the risk is the CT further increases information irregularities rather than narrowing the gaps, as it enables large accounts to benefit even more from arbitrage opportunities the retail investor will never be able to exploit.

The risks

There’s also the danger that even more trading volume will move to off-venue execution as a result of a CT which is the least ideal outcome from the perspective of the regulator. It may also be difficult to build a feed that is sufficiently resilient itself but that can also compensate for its contributors’ insufficiencies, i.e., maintaining a high quality of price information where significant datapoints are temporarily missing.    

With all that in mind, it is fair to say, a CT, no matter how well-intentioned, if not designed carefully and accurately, could potentially achieve different, and less desirable, effects to those originally intended. Therefore, one could argue the focus should have been on initiatives which help move as much trading volume as possible to on-venue execution, where regulation has ensured the levels of transparency, protection and execution quality are already very high.