EC bids to clarify ban on prop flow in dark pools

The European Commission today sought to clarify MiFID II proposals on allowing banks’ proprietary trading flow into their dark trading venues and also asserted that contentious rules on electronic trading and market making could be re-assessed.
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The European Commission today sought to clarify MiFID II proposals on allowing banks’ proprietary trading flow into their dark trading venues and also asserted that contentious rules on electronic trading and market making could be re-assessed.

Speaking at the TradeTech Liquidity conference in London, Valérie Ledure, senior policy officer, Securities Markets, in the European Commission’s Directorate-General of Internal Market and Services, said banks could continue to conduct proprietary trading in Europe, but would not be allowed to execute prop flow in their own crossing networks that also contain client orders. Such broker-operated crossing networks will be categorised as organised trading facilities (OTFs) under the current draft of MiFID II.

“We are banning prop trading because we want venues to be neutral. This doesn’t mean banks cannot prop trade. Just not in their own entity where clients are trading,” said Ledure. “[Banks] can go to another venue to prop trade.”

Confusion has surrounded the Commission’s treatment of prop trading and a rule in the draft of MiFID II issued last month bans banks from engaging in the activity in some types of venues, specifically the newly created OTF.

The Commission admitted that its new OTF category was defined broadly on purpose, as an all-encompassing definition to capture existing platforms that are currently not regulated, as well as new types of platforms that will emerge in the future.

“The rationale is that if you carry out the same activities, then the same rules should apply. In practice we wanted to capture broker-crossing networks and inter-dealer platforms,” said Ledure.

Under its current wording, a broker-crossing network which crosses with its own proprietary flow will be considered a systematic internaliser (SI), while those which allow third-party access would be reclassified a multilateral trading facility (MTF).

“Banks are able to operate both an OTF and a systemic internaliser,” said Ledure. “They are also allowed to have an SI and an OTF in the same instruments, but they cannot trade that instrument on their own [crossing network].”

On provisions the Commission has inserted into MiFID II to curb perceived adverse effects of high-frequency trading (HFT), Ledure admitted Brussels had “come late to the debate”.

“We want to address market integrity issues and safeguard investors,” Ledure said. “We have tried to explain clearly what type of HFT is abuse and we want to know which algorithms are behind it.”

Under MiFID II, investment firms using algorithms or HFT strategies would be required to act as a quasi-market maker and provide liquidity on regular on-going basis. The requirement has been met with harsh criticism in the industry, which has branded it unworkable and tarring all electronic trading with the same brush.

“The liquidity provision has been highly controversial,” admitted Ledure. “We phrased it very broadly. Personally, I am open to improving this provision.”

Kay Swinburne, Conservative MEP for Wales, a member of the European Parliament’s Economic and Monetary Affairs Committee and a former investment banker, said prior to the Commission’s MiFID II draft, Parliament had already “debated long and hard” the market maker provision but had “stepped away” from the idea.

“I know some members of Parliament are already framing amendments to this section,” Swinburne said, imploring the industry actively participate in the legislative process.

To help with this dialogue, Parliament yesterday issued a questionnaire on MiFID II. The questionnaire, open to interested parties who wants to contribute to the debate, looks at all aspects of the Commission’s proposed changes to MiFID, including obligations of trading venues and restrictions on electronic trading. The deadline for responses is 13 January 2012.

Swinburne asserted that the industry should expect key provisions of MiFID II to be implemented sooner rather than later.

“If you think you have breathing space until 2014 to operate your venues as you currently do, think again,” warned Swinburne. “In the interests of market efficiency, the industry should demand solutions be put in place under current regulations. We don’t need to wait until MiFID II becomes law to implement some of its measures.”

After all three legs of European government – the Commission, Parliament, and Council –reach agreement on the text of MiFID II, the European Securities and Markets Authority (ESMA) will develop the technical details of the new rules. According to Swinburne, the next draft of MiFID II and MiFIR could be ready by February 2012, with March set aside to exchange views in Parliament. In July, the committee would vote in time for trialogue discussions in September. This would mean Brussels could reach “some agreement” by the end of 2012.

“ESMA would need one-to-two years to develop the details, so under the most optimistic timeframe, we would expect implementation by 2014,” Swinburne said. “But there is no excuse not to put many parts of MiFID II in place now. ESMA is already looking into how this could be accomplished, as are certain national regulators.”