Trading Venue Perimeter: US vs EU differences but equally unpopular

Kelvin To, founder and president of Data Boiler Technologies, discusses the differences between US and EU trading venue perimeters.

The SEC’s proposed amendments concerning Investor Protections in Communication Protocol Systems (CPSs) and Alternative Trading Systems (ATSs) in the US versus the ESMA’s opinion on the trading venue perimeter in Europe are quite different. The Rules, despite the policy objectives and their unpopularity, are about the same. This article aims to decipher the regime differences, as well as explain why some of the changes are between a rock and a hard place.

Prior to the ESMA opinion in CP70-156-4978, the FCA in UK have stated in HM Treasury consultation that, “it is sometimes not clear if these technology firms, who are bringing buyers and sellers together on an informal basis, need to be authorized as a Multilateral Trading Facility (MTF)”. A review paper by the Dutch AFM stated, “It is also becoming clear that the boundary between a regulated multilateral venue and a technology/communication platform is thin. As Mifid II has significantly raised regulatory burdens for operating a trading venue, this has incentivised firms to avoid these costs and to operate close to or beyond regulatory delineations. Sometimes even unintentionally…”

Some commenters in the US, including SIFMA, oppose amending the SEC Rule 3b-16(a)(1) to change “order” to “trading interest” or recommend the Commission consider providing additional clarity on this term. The SEC did provide a definition of “trading interest” to mean “order or any non-firm indication of a willingness to buy or sell a security that identifies at least the security and either quantity, direction (buy or sell), or price” per proposed Rule 3b-16(e) and Rule 300(q). In our opinion, the term “trading interest” is non-novel and commonly used throughout the US and EU capital markets to mean largely the same as the SEC proposed definition. Indeed, “trading interest” is one of the key deterministic factors to consider what constitutes a “multilateral system”.

The US SEC is proposing to replace the language of “bring together order” with a broader definition of “bringing together buyers and sellers”. Without the word “order” in the proposed Rule 3b-16(a)(1) or “trading interest” in the proposed Rule 3b-16(a)(2), the interpretation of the provision may go beyond the intent to engage in buyer/seller relationships. Whatever formalisation of arranged transactions or the ultimate execution of transactions may become irrelevant in context of this US proposed Rule. To determine the activity does not require authorisation in the EU. The 3 characteristics about the functioning of the arrangement per Recital 8 of MiFIR are concise and absolute:

  • Consist of an interface that only aggregates and broadcasts buying and selling interests in financial instrument;
  • Neither allows for the communication or negotiation between advertising parties nor imposes the mandatory use of tools of affiliated companies;
  • No possibility of execution or the bringing together of buying and selling interests in the system.

Modern technologies would have established “rules” or “protocols” to automate “streaming” and/or other “interaction” with on-demand requests. Such request may or may not be an “order” or “trading interest” or something else. The ESMA has stated “the type of technology used or the fact that it is an automated or non-automated system, does not determine whether it is a system.” Some may argue these EU requirements as being too harsh, especially those who advocated for a “craft-out” of block-chain technology.

If a CPS or an ATS prefers to not register as an Exchange in the US, the only escape they have to avoid falling within the SEC Rule 3b-16(a) is – restricting their system to display bona fide, non-firm trading interest or do not establish rules or operate a trading facility. It seems contradictory with the broadest possible definition of “bringing together buyers and sellers” if the SEC’s proposal is adopted. Further clarification is required. Also, even in absent of rules which facilitate interaction of trading interest, ESMA has stated that whether a firm “would reach out to other clients to find a potential match when receiving an initial buying or selling interest, would also be characterised as a system”. Does the US SEC apply the same or similar judgement here? If not, “Bulletin board” type of entities in the EU would be uneasy if their business in the US may be brought within scope of CPSs that requires to be registered as Exchanges or ATSs.

“Inward looking OMS”, “general-purpose communication system”, and “extension of the trading venue for formalise negotiated or pre-arranged transactions benefit from Article 4 waivers that do not seek authorisation as trading venue” in the EU, may all of a sudden be subjected to compliance requirements of Exchange or ATS if they have business in the US. This proposed amendment is like a knife above every vendor’s head. “Rule by fear” would never solidify civil obedience to a police-state. It is a slippery slope when deviating from an objective basis in establishing clear boundaries between prohibited and permissible activities to delineate rights and obligations.

Subjective judgements by a ruler’s taste lead to disputes and arguments detrimental to the productivity of our industry. Alleged violations would not reach definitive conclusions. More cases will end up in settlement favoring the ‘Too Big to Fail’ (TBTF) rather than seeing justice prevails. Victims may not be identified in many of these cases therefore settlement fines are divided among regulators. Officials craving for evermore powers may lead to unethical behaviors in exploiting the governed. We despise self-serving rules that benefit a government agency more than serving the public’s best interest.

Comparatively, the 591-pages SEC proposed amendments look blurry and cumbersome, while it may be seen as a positive among TBTF elites. They have wider shoulders to bear the compliance burden than smaller firms. The US requirements largely focus on written policies and standards, usually those victimless cases which end up in settlements. A “toothless rule” won’t bite; it will not help prosecute wrongdoers in recouping losses for the harmed victims. In turn, TBTF elites may factor in such regulatory fines and settlements as part of their costs of doing business.

Both the US and EU’s changes are between a rock and a hard place. The precise and absolute terms in the 34-pages European version may sound appealing to those who do not operate close to the edge (grey areas). Yet, the requirements come along with clear definitions that can hurt the industry negatively. For example, the requirements might be too strict or rigid that an OTF operator, which is usually a broker-dealer, would be prevented from trading against its capital. To some extent, it leads to drying up of market liquidity, a detriment to institutional investors. ESMA seems to be not proposing to establish a threshold-based regime for OTFs, while the US proposed rules afford such leeway.

A jurisdiction or sovereign state may apply judgements for the most suitable, efficient, and effective ways to govern and regulate the orderly functions of society. We are good with regime differences over “subjective” matters, such as how much discretion or rights that one should have or is entitled to, and they bear the corresponding obligation and/or regulatory burden. These kinds of differences promote healthy competition across nations and/or regions. However, the difference this time pertains to the characteristics or principles in determining when a “subject” or “object” meeting certain condition(s) would be considered “what”. We dislike both the US and EU policies that brought too many entities within scope. There is no point in picking the ‘pros’ and the ‘cons’ between the two bad policies. Policy makers should instead look for alternative solutions, which we have identified and recommended.