Trading venues have been around for centuries, but with the market structure being subject to ongoing and fundamental change, some of their pivotal functions - such as providing a platform for mutual floor trading between brokers - have disappeared entirely. Other core functions, such as acting as a capital hub for corporates or enabling secondary market trading between multiple types of investors and thus contributing to price discovery, have remained. A number of developments, predominantly triggered by technological advance, have been steadily moving more and more trading volume from on-venue execution to execution over-the-counter (OTC).
The majority of retail trading turnover has been taken to OTC execution from the very beginning. After the introduction of regulatory changes and with the number and sophistication of retail investors growing consistently, alternative ways to trade have come to the fore.
In particular, Multilateral Trading Facilities (MTFs) have emerged as suitable alternatives for retail investors to getting their trades executed OTC. Traditionally, retail investors did not pay too much attention to where their brokers put their clients’ trades for execution as long as transaction fees remained low or zero. Growing in sophistication, they now increasingly look into details around execution, appreciating the transparency and security of regulated trading environments – with MTFs constituting one such environment.
MTFs were first introduced in the course of the initial version of the Markets in Financial Instruments Directive (Mifid) in an attempt by European policymakers to increase competition among trading venues. Like traditional stock exchanges which are defined as Regulated Markets (RMs) by Mifid, MTFs – which are of course regulated, too – are subject to extensive pre-trade and post-trade transparency requirements, non-discriminatory access requirements (including the obligation to consistently apply and publish prices and charges) and the maintenance of rulebooks governing their operational frameworks. They are neither allowed to trade against own funds nor to interposition themselves between orders, nor to apply any discretion over whether they execute an order or not.
Prior to the introduction of Mifid, on-venue execution for retail investors meant trading via an RM. Given the development of retail trading patterns and the progress of technology over the recent decades, the cost argument was reasonable until some years ago. While institutional investors had and still have other reasons for avoiding on-venue execution of their orders, for retail investors transaction costs had been the most striking argument to do so. For them, the cost of on-exchange execution did more than offset the benefits involved. In other words, trading on-venue was too expensive to compensate for components that are not reflected in fees but are incurred because a transaction is not being executed at the best available price or to compensate for other features not available off-venue.
Price impacts vary as function of market performance, and they can be significant not just for the end investor as recent months have shown. Some brokerage offerings give the impression of transparency, modernity and absolute cost efficiency. However, in executing client orders OTC essential transparency regulations are being circumvented which, in turn, distorts price formation and liquidity.
An MTF offers the protective framework of a regulated trading platform instead. Investors see the actual traded volume at each point of supply and demand; that is, they benefit from knowing that they can buy or sell their position at a better price than what they might have thought was a good reference. They, as well as the members of the MTF – issuers, market makers, banks and brokers – can thus compare venues and determine the most eligible one for their need. Such comparability had been at the heart of the regulatory concept of increasing trading venue competition.
Increasing competition among trading venues may have been one express goal of the European Union when they established the trading venue regime under Mifid and the concept of MTFs in particular. This, however, had not just been done for the sake of competition but with the clear intention to move more trading volume towards on-venue execution. Another initiative that has been published recently by the European Securities and Markets Authority (ESMA) follows the same approach. Its Opinion on the Trading Venue Perimeter, a legally binding act having become immediately effective upon publication, clarifies which systems are “multilateral systems” under Mifid II, thus being obliged to seek authorisation as a trading venue. In particular, the Opinion provides more narrow definitions of what a multilateral system, a category introduced under Mifid II, effectively is.
ESMA stated that “the combination of the changes introduced in Mifid II and the continuous innovation in financial markets has led to different interpretations within the EU whether a system needs to be authorised as a trading venue”. In this respect, it aimed at harmonising interpretations on new technology providers and request for quote systems which may, in some instances, operate without proper authorisation.
This can be clearly understood as an attempt to reinforce the idea of moving as much trading as possible to trading venues throughout the Union.
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