Proposals to raise minimum order sizes for systematic internalisers (SIs) as part of the Market in Financial Instruments Regulation (MiFIR) risk raising the cost of trading for institutional investors.
With new rules effectively banning the use of broker crossing networks (BCNs), most bulge bracket firms are set to refocus their OTC equity trading on behalf of clients onto their systematic internalisers.
But following the publication of a discussion paper by the European Securities and Markets Authority (ESMA), proposed changes to SI rules were subject to intense scrutiny during two hearings held at the regulator’s headquarters in Paris last week.
Brokers are concerned that a change in the ‘standard market size’ thresholds –essentially minimum trade sizes that must be reached to gain a pre-trade transparency waiver for an OTC equity trade – will impact the ability of brokers to support SI trades and raise costs for investors.
"There are some concerns about the thresholds for standard market size that ESMA has proposed. ESMA’s analysis has concluded that the current standard market size is mis-calibrated,” said Juan Pablo Urrutia, European general counsel for agency broker ITG. “However, under the MiFID II/MiFIR ESMA discussion they are proposing to leave the standard market size as is or to increase it. ESMA suggests that there are policy reasons for going against their own analysis and my view is that this blatantly shows the politicisation of ESMA in what should only ever be a technical process.”
ESMA’s concerns seem to be supported by the use of SIs since they were first introduced as part of MiFID in 2007. While most brokers are considered to be systematic internalisers, they have made limited use of the trading mechanism, instead preferring to use BCNs, which have no pre-trade transparency obligations. With trades being forced onto SIs by the BCN ban, the sell-side believes it is vital to revise the thresholds in order to avoid increased trading costs.
ESMA has set out three options for changing standard market size and, while the first proposes reducing standard market size for less traded shares of under €10,000 average daily trading value (ATV) from €7,500 to €5,000, it has outlined its preference for making all trades with less than €20,000 ATV to have a standard market size of €10,000 as this is in in line with MiFID goals of reducing dark trading. Its third option is to keep SI thresholds at the same level they are today.
It is believed this move would be more in line with other changes in MiFIR, including caps on dark pool volume that falls outside of the large in scale block trading waiver to discourage small dark trades.
“If SIs are required to provide firm quotes at higher standard market size thresholds, it could mean more capital is required to trade OTC through an SI, increasing spreads and ultimately raising the cost of trading for investors," said Daniel Mathews, senior vice president of equities market structure at Citigroup Global Markets.
Urrutia warned that legislators’ hopes of improving price formation by driving more of the buy-side to lit markets are unlikely to succeed.
He added: “While some regulators and policymakers might cynically think that this could result in more flow being pushed out to the lit markets, the better view probably is that the buy-side will look at any substantively higher cost of trading and simply decide not to trade."
Aside from the increased threshold, equity trading on SIs is unlikely to cause a major upheaval for the buy-side, and Urrutia thinks MiFID II will result in much more regular use of SIs.
"This time, systematic internalisers will take off because bulge-bracket brokers and others that may trade on an OTC systematic basis won't be able to avoid pre-trade transparency obligations under the new regime," he said
"For the buy-side, nothing should really change as they will still be able to perform large size trades (i.e. above the standard market size) via their broker's SI without having to make their orders public pre-trade."
However, ESMA’s discussion paper has revealed some additional potential rule changes which Mathews believes may affect intuitional investors.
"ESMA has proposed the identity of an SI is published for trades conducted through an SI. Publishing the identity of an SI won’t increase price formation, but will potentially expose risk positions,” he warned.
"ESMA has also proposed SIs will have to provide periodic reports on execution quality. The discussion paper is light on detail, but potentially this could place more obligations on the buy-side to analyse these reports. It seems they are treating SIs like a trading venues, which they are not because SI’s provide capital and are bilateral."
The effective banning of BCNs by a new trading obligation, that requires investors to execute on either a regulated market, multilateral trading facility (MTF), OTF (which will not be available for equities) or SI, means brokers will need to examine how they can provide dark crossing services for clients.
Some that wish to maintain a higher level of control over how client orders are exposed may prefer the SI route, while others may focus on their MTF, as UBS already does, though accept that they will have less control over the kind of counterparties active in the pool.