A row between some of Europe’s biggest exchanges and brokers over how brokers offering internal crossing services are classified under MiFID has been reignited.
In a meeting with the Committee of European Securities Regulators (CESR), the body charged with ensuring consistent regulation across European member states, the Federation of European Securities Exchanges (FESE) called for brokers’ internal crossing engines to be classified as either systematic internalisers (SIs) or multilateral trading facilities (MTFs) rather than over-the-counter (OTC) services.
CESR held separate meetings with FESE, which represents 42 of Europe’s exchanges, and four brokers – Goldman Sachs, Credit Suisse, Morgan Stanley and UBS – on 15 July, to explore the role of OTC trading in Europe’s equities markets.
Brokers’ internal crossing engines, also referred to as dark pools, allow brokers to match client orders either with each other or with their proprietary order flow without going to an external trading venue. This can be a lucrative business for sell-side firms as it potentially allows them to earn commission from both sides of a trade.
MiFID defines systematic internalisers as “an investment firm which, on an organised, frequent and systematic basis, deals on its own account by executing client orders outside a regulated market or an MTF”. SIs are required to publish pre-trade quotes for orders in liquid shares below a standard market size. OTC trades, according to MiFID, are ad-hoc, irregular, carried out with wholesale counterparties and as part of a relationship characterised by dealings above standard market size, and performed outside the systems usually used by a firm for its SI business. These are subject to post-trade transparency only. Banks registered as SIs under MiFID include BNP Paribas, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs and UBS.
However, European exchanges complain that only a small number of crossing engines are registered as SIs, and a majority do not fall into any of MiFID’s three venue types – SI, MTF or regulated investment exchange (RIE). As a result, they are considered OTC services and subject to less stringent regulations than other venues, despite performing similar functions. FESE estimates that 41% of total European trading in May was conducted over-the-counter, and argues that the vast majority of this was carried out in non-SI broker crossing engines. By comparison, the federation estimates that just 2% of trading took place in SIs over the same period.
FESE contends that the large OTC market share, which it says has remained static despite concerns over bilateral trading that arose following the collapse of US investment bank Lehman Brothers last September, is cause for speedy action.
“There is a lot of trading – more than people think – that isn’t classified under a systematic internaliser, regulated market or multilateral trading facility,” Burçak Inel, deputy secretary general, FESE, told theTRADEnews.com. “These broker dark pools are largely comparable with the functions provided by classified trading venues and have an unfair competitive advantage.”
However, some brokers argue that neither the MTF or SI classifications are appropriate for their crossing services. “We operate a successful business model in the US with Citi Match, and we exported that same model to Europe. The model fits into neither the MTF or SI classifications, so we chose to operate it as an OTC venue,” said Jack Vensel, head of electronic execution, EMEA, Citi. “Our regulators and clients already hold us to stringent best execution standards, and we are open to regulatory oversight wherever necessary. Not being classified as an MTF or SI does nothing to change our best execution obligations.”
Others argue that brokers’ and trading venues’ matching services differ too greatly to be subject to the same rules. “Brokers have fiduciary duties to provide best execution to clients,” said one broker, who asked not to be named. “Exchanges and MTFs provide the execution function, and are very different entities that should be regulated differently.”
Some sources dismissed concerns from FESE and its members as a bid to drive more OTC trading onto exchanges, and pointed out that even before MiFID, brokers provided off-exchange crossing against internal flow and OTC business made up a large portion of overall trading.
The meetings with FESE and the four brokers will form part of CESR’s MiFID review, which will ultimately informs the European Commission’s evaluation of the directive, expected to take place next year.
The review began in January with a call for evidence from CESR on the impact of MiFID on secondary markets functioning FESE members the London Stock Exchange, Nasdaq OMX and NYSE Euronext were among individual respondents that expressed concern over the role of broker dark pools.