It seems that European regulators are still not totally clear over how best to bring broker crossing networks, operated by investment banks, under the remit of new legislation.
Under the original Markets in Financial Instruments Directive (MiFID) in 2007, there were three categories of trading venue set in stone—regulated markets, for the existing exchanges; multilateral trading facilities (MTFs), for venues that brought together buyers and sellers in a non-discretionary way and described as a form of ‘exchange lite’; and systematic internalizers (SIs), which were firms that executed orders from its clients against its own book or against orders from other clients.
However, the third type of trading venue, SIs, never really took off and broker crossing networks have operated outside the classifications ever since under the guise of over-the-counter equity trading. But under upcoming European regulation, an updated version of the 2007 directive, dubbed MiFID II, there will be a crackdown on the practice but, it seems, there still isn’t a clear path as to how best to go about it.
Last October, when the European Commission published its MiFID II legislative proposals, a new trading venue definition, known as an organized trading facility (OTF), was added to the mix aimed at better regulating broker crossing networks but intense lobbying in Brussels by incumbent exchanges—who were against the plan as they argued that brokers would not be subject to the same stringent rules such as over non-discretionary execution as themselves—seems to have pushed this plan off course. Under the OTF proposals, owners of the platforms would not have been allowed to trade on the platform using their own capital.
However, it appears that Europe’s politicians are now considering re-establishing the SI category in a move to allow broker platforms to engage in matched principal trades—a transaction where the firm/operator sits in the middle of the trade and becomes the buyer to the seller and the seller to the buyer—to comply with new regulations governing OTC trades that will see all OTC trades pushed on to regulated exchanges by the start of next year at the behest of the G20 group of nations, in a bid to prevent another financial crisis.
First proposed in March, many market participants are still unclear as to how the changes may play out.
“We think we can make the systematic internalizer category work for single-dealer platforms,” said Kay Swinburne, a UK center-right MEP, who is also a member of the influential Economics and Monetary Affairs Committee at the European parliament and one of five deputy rapporteurs overseeing the MiFID II proposals. “We thought this was the better way—rather than amend the multilateral element of OTFs, we will try to adapt the SIs.”
"They are a formal organized trading venue. They should be recognized as such and therefore be allowed to fulfill the G20 obligation. It's a nice, simple argument. We don't know how much traction it will have, but we have tested it with a few people.”
A number of investment banks in the EU operate broker crossing systems that match client order flow internally such as Citigroup, Credit Suisse, Deutsche Bank, JP Morgan, Morgan Stanley and UBS.
Generally, these firms receive orders electronically, utilize algorithms to determine how they should best be executed, given a client‘s objectives, and then pass the business through an internal system that attempts to find matches. Some systems match only client orders, while others also provide matching between client orders and house orders. Broker crossing networks do not show an order book and simply aim to match orders; due to this nature they are sometimes compared to dark pools, which are classified as MTFs.
The new MiFID II proposals are likely to force the banks to change their business models and some are already looking at establishing new internal trading venues that allow them to operate within the rules.
Markus Ferber, a German member of the European parliament who is responsible for guiding the revised version of MiFID through to the next stage of approval in Europe, has said repeatedly that broker crossing networks should fit into existing classifications.
“Your rapporteur questions whether the creation of a new category is the right way to capture organized venues which are not caught by the already existing categories,” said Ferber in March.
However, recent amendments to MiFID II filed by both the Council of Ministers and members of the European Parliament reveal that brokers may be allowed to conduct matched principal trades under the OTF banner after all. The one major sticking point to all of this, however, is that under the October proposals, OTFs must operate as MTFs—something that broker crossing networks will fail to meet.