The spirit is willing, but the drafting is weak

Asking firms to operate in the spirit of the law will not solve Mifid trading venue confusion

Lawmakers have taken an evangelical approach to new market rules. With the second Markets in Financial Directive (Mifid II) set to go live in Europe in January, firms are struggling to understand what category of trading venue they fall into, and the limitations of each category. In response, regulators are asking firms to have a little faith that if they act in the spirit of the rules, they will be saved.  

Several firms say they believe in that approach and warn asking for more prescriptive rules could make matters worse. That’s likely to be true, but unfortunately, so is the fact that faith and spirit are not concepts that work well in cross-border regulation – because firms and the national regulators supervising them need to come to the same conclusion on what the spirit of the rules means. For the question of trading venue categorisation, the issue is two-fold.

First, matched principal trading – where a firm takes balance sheet risk only briefly before finding a matching offset trade – has been made into an unwanted offcut of Mifid II. It has to squeeze into the tiny space left over between the limits of bilateral systematic internalisers (SIs) and multilateral organised trading facilities (OTFs). It looks multilateral, but OTFs can only do a limited amount with the consent of clients and not for cleared derivatives. It’s technically defined as dealing on own account, but SIs can only do it on a very limited basis because, really, in spirit, it’s multilateral.  

Secondly, when Mifid was extended to non-equity classes, although the new OTF concept was created to take into account some market specificities, the category for SIs was just stretched over. That’s awkward because it implies their activities should be comparable across asset classes. So a firm has to have a lot of faith that regulators will understand, for every market, what it actually looks like to be operating within the spirit of the rules.

By definition, an SI can engage in matched principal trading, but only if it doesn’t occur on a “regular and not occasional” basis, which is clearly a non-scientific, very faith-based measurement. Market participants say what is considered a normal amount of matched principal trading will depend on the asset class. SIs in fixed income will do a lot less of it, because markets are less liquid. But trading in equities happens at much higher speeds, and so an SI in equity might tend to lay off client risk more quickly, more often.

The upshot is that with the Mifid deadline just around the corner, some firms – especially in non-equities classes – don’t know what category they fall under. They may engage in a mix of activities, and unless thresholds are set, they may be unsure if their mix makes them a multi- or a bilateral entity. To make matters more confusing, the interpretation of the multilateral threshold seems a lot lower than anticipated.

To back up their fears, a banker called out his colleagues at a recent industry conference as irresponsibly poking around just to see how far they could push the limits on matched principal trading

Then, firms that have figured out which category they fall into are left guessing on what the limits of that category are. This is where tempers flare a bit. European lawmakers are furious at reports that SIs operating in equities might be putting together networks with high-frequency trading firms, which would allow them to trade bilaterally at such speeds they are in spirit acting multilaterally.

To back up their fears, a banker called out his colleagues at a recent industry conference as irresponsibly poking around just to see how far they could push the limits on matched principal trading.

That certainly sounds nefarious. But put another way by a different banker: “What the politicians are trying to do right now, unfortunately, is using regulation to fight technology.”

His argument is there is no going backwards in the world of trading. Former members of dark pools will continue to send orders to all their fellow former members, following the rules, but “economically, change nothing”, he says. These days, banks see matched principal trading as an important way to keep their balance sheets lean, as incentivised under other new regulations.  

“Sending letters around saying that doesn’t comply with the spirit of the rules doesn’t make sense, as this is now a rules-based regulation, not a principles-based regulation. If the rule doesn’t exclude it, people will do it,” he says.

Regardless of whether these SIs are acting in bad faith or not, it’s clear that depending on the spirit of the law, to lead to comparable compliance across jurisdictions could produce a regulatory Tower of Babel.