Markets View – November 2022

Welcome to the November edition of Markets View. Regulators on both sides of the Channel have clearly been busy with markets-based initiatives, which will be more trick than treat for some. In this bumper issue, we look at the FCA’s consultation on the trading venue perimeter, ESMA’s call for evidence on pre-hedging, the FCA’s Market Watch 70 on market conduct and transaction reporting issues, ESMA’s proposals to address high prices and volatility in energy derivatives markets, the Bank of England’s (BoE) proposal to modify the derivatives clearing obligation (DCO) to reflect USD interest rate benchmark reform and ESMA’s updates to its Q&As on commodity derivatives and market structures topics. Part 1 of this edition is set out below but keep an eye on your inboxes for Part 2.

As always, please do reach out to us with any feedback or questions.

Trading arrangements come under increased FCA scrutiny in trading venue perimeter review

The FCA has published a consultation paper (CP) on proposed new guidance on the trading venue perimeter. The FCA is concerned that some firms may be operating trading arrangements without being authorised and regulated as trading venues.

As was noted by many respondents to HM Treasury’s Wholesale Markets Review, the post-MiFID2 regime is notoriously difficult to navigate due to the layered definition of a multilateral system (MLS), especially when coupled with rapid technological development. As a result, there is a lack of certainty about the permissions firms may require and many firms have found it hard to distinguish certain arrangements and systems, such as bulletin boards, from business models requiring authorisation.

Scope of the proposals

The FCA is proposing new guidance in the Perimeter Guidance Manual (PERG) to clarify the definition of an MLS as well as new Q&As on the application of the general guidance to specific types of trading arrangements. Following the finalisation of the FCA’s guidance, it proposes that Q&As 7, 10, 11 and 12 in Section 5 of the ESMA Q&As on MiFID II and MiFIR market structures topics should cease to form part of its supervisory expectations.

Definition of an MLS

In its proposed amendments to PERG, the FCA sets out the characteristics it considers relevant to the interpretation of the different limbs of the definition of an MLS:

• Characteristics of a system or facility—The FCA will consider if a system has features intended to enable the interaction of trading interests, eg, any restrictions on functionality or if operator remuneration is linked to the interaction of interests. On this basis, the FCA helpfully distinguishes MLS and general-purpose communications systems (GCS), such as chatroom facilities. Generally, GCS should not amount to trading systems / facilities.
• Interaction within the system—The FCA emphasises that interaction is the exchange of information relevant to the essential terms of a transaction (price, quantity or subject matter) and other actions signalling intent to conclude a trade. Therefore, a system which enables such information to be inputted and responded to in the system (eg, by communicating / negotiating in relation to this information) would meet this limb, ie, interaction does not require execution and settlement of a transaction to be entered into within the system. On this basis, though, neither portfolio compressions services nor post-trade confirmation services would constitute an MLS by themselves.
• Multiple third-party buying and selling trading interests—In the FCA’s view, what matters is whether a system, at the point of entry, is designed to enable one person to interact with others. Therefore, just because two persons negotiate within a system, and they just do so between themselves, this does not automatically mean that the system is bilateral rather than multilateral.

Generally speaking, the proposed guidance may not be sufficient to remove all ambiguity that exists around the perimeter, eg, on one read, RFQ systems could be considered to be caught by the guidance on the definition of multiple third-party buying and selling trading interests.

New Q&As on the application of the general guidance to specific arrangements

Bulletin boards

The issue of bulletin boards has been a continual source of questions and interpretive challenges since the implementation of MiFID2.

The FCA highlights that while trading interests can be posted on a bulletin board, they should not interact. It clarifies that it would consider an arrangement as going beyond only operating a bulletin board if:

• it matches trading interests in the system;
• it allows users to respond to other trading interests, including by communicating in relation to, negotiating or accepting the essential terms of a transaction; or
• users can commit to enter into contracts for the sale / purchase of financial instruments (ie, execute transactions) within the system.

The FCA indicates that an operator of a bulletin board could, though:

• provide for the publication or sharing on a case-by-case basis of contact details, so that users can contact each other bilaterally outside the system;
• make available template documentation for download by users of a bulletin board for the negotiation and execution of transactions, noting the essential terms of transactions should not be completed by the operator; and
• provide post-trade services, including in relation to settlement, eg, assisting with the transfer of funds.

Voice broking

In the FCA’s view, merely arranging / executing trades by telephone is not enough by itself to constitute an MLS, but maybe when combined with other modes of execution. For example, a firm that operates a platform where trading interests of clients are broadcast to users and then engages in voice broking to enable negotiations may be operating an MLS.

Internal crossing by portfolio managers

Portfolio managers exercise discretion in relation to the assets they manage. Therefore, a portfolio manager executing trading interests relating to the portfolio of one client against the interests relating to the portfolio of another, in the exercise of this discretion, should not be considered to be operating an MLS.

Blocking onto trading venues

Where a firm operates a system only for blocking trades onto a regulated trading venue, consistent with the intentions of the parties to the underlying transactions, these arrangements should not amount to the operation of a multilateral system.

Comparison with European developments

The CP largely follows ESMA’s consultation on the definition of multilateral systems and the trading venue perimeter in seeking to bring more arrangements under the regulatory umbrella. However, the ESMA review takes a far more expansive view of what constitutes an MLS, eg by including the use of execution management systems. This divergence will lead to an increase in costs and some operational burden although it is unlikely to be significant.

Next steps

Once it has considered the responses of firms to the CP, the FCA aims to publish a policy statement in Q2 2023. In the EU, ESMA’s opinion on the trading venue perimeter is expected to be published later this year.

ESMA probes concerns about market abuse and conflicts of interest in call for evidence on pre-hedging

Responses to ESMA’s MAR Review CP raised concerns from market participants (MPs) that pre-hedging behaviours may entail market abuse risks and may not be beneficial for clients. Targeting these concerns, ESMA launched a call for evidence (CfE) to help it shape guidance on (i) MAR-related issues, clarifying what should be considered MAR-compliant vs front-running, and (ii) MiFID2-related procedural considerations for market makers on documentation, transparency, and internal policies. The CfE only focuses on RFQ systems and where a liquidity provider trades ahead of the acceptance of a quote from a client. Trading ahead of pending orders is not covered. Given pre-hedging remains a controversial subject with fundamentally differing views existing in the market, firms should consider the CfE and any follow-up from ESMA carefully. The views expressed by ESMA in the CfE may have implications for the positions taken by firms on pre-hedging and any related policies, processes and procedures they have in place.

Defining pre-hedging practices

ESMA notes that, while the term isn’t defined in EU law, there is a general understanding among market participants about what constitutes pre-hedging. ESMA says that pre-hedging can be characterised as any trading activity where (i) an investment firm is dealing on its own account and the trading activity is undertaken (ii) to mitigate an inventory risk foreseen due to a possible incoming transaction, (iii) before that transaction is executed, and (iv) at least partially, in the interest of the client / to facilitate the trade. ESMA flags that it understands (and hence may expect) that pre-hedging is primarily a wholesale markets activity between investment firms and eligible counterparties (ECPs) but asks firms if the practice also takes placed with respect to RFQs from retail or professional clients.

Arguments for and against pre-hedging

Against pre-hedging, ESMA cites that:

• a significant number of respondents to the MAR Review CP considered that it entails market abuse risks;
• in a competitive RFQ process, if a liquidity provider with “first-mover advantage” were to pre-hedge, it might trigger a price movement affecting quotes subsequently offered by others and affect the price at which the trade is executed;
• a clear risk management rationale does not seem to exist for trades in liquid or very liquid assets; and
• pre-hedging certain derivatives trades through a trade in the underlying might affect the final trade price in a way which is more favourable to dealers and that, while a dealer can protect the customer’s interests by executing the hedge in a way that minimises price impact, this does not tend to happen in practice.

In favour of pre-hedging, ESMA says:

• pre-hedging is a common practice in other jurisdictions provided certain conditions are met, eg, in North America, and this position is also taken by major industry bodies, eg, the GFXC (Principle 11 and Guidance Paper) and the FMSB Standard for the execution of large trades in FICC markets;
• responses to the MAR Review CP from firms (which pre-hedge their possible exposure) claimed that the market risk reduction achieved translates into better quotes for clients, reduced volatility and lower costs for the market overall; and
• responses to the MAR Review CP also indicated that pre-hedging is crucial for markets in illiquid instruments (eg, certain currencies or rates) and transactions relating to them (eg, bond issuances).

Pre-hedging and MAR

ESMA seeks views on whether an RFQ could be “price sensitive” or “precise information”.

• Price sensitive—ESMA considers that an investor would take an upcoming RFQ into account in its decision making if the corresponding transaction were to have a significant effect on the price of the relevant financial instrument. ESMA is asking for views as to the most relevant factors for this analysis: eg, the size of the RFQ, market conditions (type of trading, time of day, volatility, etc), and liquidity.
• Precise information—ESMA flags that, while precision seems obvious for RFQs, it may not be clear for two-way quotes, ie, an RFM. However, pointing to Lafonta vs. AFM, ESMA indicates that an RFM could be precise information so long as price variation is expected. Widening the potential scope of this limb, ESMA is also seeking views on whether an RFM could be considered precise on the basis of past commercial relationship, market conditions or the news flow.

ESMA is also seeking views from MPs regarding a non-exhaustive set of possible indicators that can be useful to evaluate the legitimacy of pre-hedging practices across four different factors.

• Subjects who could legitimately pre-hedge foreseeable transactions—Consistent with the approach taken by North American authorities and major industry bodies, ESMA proposes that pre-hedging is only possible when acting as principal rather than as agent.
• Risk management—
  • As a starting point, ESMA asks for views on cases where pre-hedging is necessary for risk management, pointing to the legitimate reasons set out in the GFXC Guidance Paper and suggesting that, absent such rationale, liquidity providers should abstain from pre-hedging.
  • ESMA proposes that there must be a real likelihood of executing a transaction, which would be consistent with the FMSB Standard, and asks whether pre-hedging can be considered legitimate were an MP is aware that it will not be awarded the transaction.
  • ESMA also asks whether pre-hedging through certain financial instruments should be considered an indicator of legitimate/illegitimate activity.
• Interest and benefit of the client—ESMA is considering whether pre-hedging transactions where the liquidity provider only pursues its own interest or both its own and its client’s interest may correspond to front running. Given this wide scope, ESMA is also seeking views on whether obtaining a client’s express consent to pre-hedging on a case-by-case basis could support a presumption of legitimacy. However, it’s not clear that getting such consent would always be feasible, especially when RFQs are sent electronically.
• Liquidity of the instrument—Some respondents to the MAR Review CP flagged that, given pre-hedging following an RFQ in a liquid instrument would not seem necessary, such instruments might be an indicator of suspicious activity. However, given ESMA could not find any clear evidence on whether this is the case, it asks firms for their views.

Pre-hedging and MiFID2

In the MAR Review Final Report, ESMA notes that pre-hedging may create risks around managing conflicts of interest (COI) between an investment firm and its clients and seeks views from firms on measures which would have implications for firms’ current policies, processes, and procedures.

• COI policy—Should firms conducting pre-hedging have a COI policy specifically addressing measures to manage COI arising from pre-hedging?
• Transparency—If the COI policy is not sufficient to rule out a COI, should firms disclose to a client that an RFQ might be pre-hedged and make it aware of the potential impact of such practice on the trade so it can make an informed choice. Should firms provide quotes with and without pre-hedging?
• Record keeping—Should firms keep and provide on request records of pre-hedging transactions and related trading activity.

In the CfE, ESMA also takes aim at abusive practices of requesters for quotes. In a pre-hedging context, ESMA emphasises that obligations under MiFID2 go both ways and calls out cases whereby a large RFQ is used to obtain a benefit from the subsequent liquidity provider’s pre-hedging practices.

Improving the quality of transaction reporting and financial instrument data reference submissions

In Market Watch 70, the FCA shares with firms its recent observations on the transaction reporting and instrument reference data regimes. This edition of Market Watch will be of particular interest to investment firms, credit institutions, trading venues, systematic internalisers, and approved reporting mechanisms. This topic continues to be a regulatory priority for enforcement action: shortly after publication, the FCA fined a leading brokerage company £531,000 for market abuse surveillance and reporting failures, fined three of the firm’s directors amounts totalling over £200,000, and issued prohibitions against two of them.

Observations on transaction reporting

Reconciliation of trading records

On transaction reporting, the FCA emphasises that firms must maintain arrangements for identifying and remediating reporting issues proactively and promptly. It identifies three key issues.

• Firms are required to conduct regular reconciliations of transaction reporting data extracts with front-office records under RTS 22. But the number of firms accessing its Market Data Processor (MDP) Entity Portal to make a transaction reporting data extract requests are low—implying that some firms are not complying with these obligations.
• The FCA’s data quality alerts suggest that many firms are not conducting sufficient checks on their data. It warns that reconciliations should not be limited to certain fields or data samples that do not adequately reflect the trading scenarios and asset classes traded by a firm.
• The level of information provided in breach notifications submitted to the FCA has been of variable quality. Notifications should be comprehensive, including adequate background to facilitate a full review of the incident. Notifications with limited details and unhelpful references to proprietary reporting systems or processes are not sufficiently comprehensive. Instead, best practice is to include examples of how a field was misreported and how this will be corrected.

National Identifiers

As the FCA has previously highlighted (Market Watch 59 and 62), 1st priority national identifiers must be used if available to identify natural persons in transaction reports. The FCA continues to see firms failing to conduct sufficient due diligence when onboarding clients to obtain these identifiers and specifically calls out firms offering services to retail clients electronically, eg, via mobile apps, as the worst offenders. Best practice is:

• Not to execute a transaction until a client’s identifier has been subject to internal review and validation, which should include checking it against the standard outlined in the ESMA Q&A on MiFIR data reporting;
• To review identifiers received to ensure no duplicates exist within client databases; and
• To ask clients for explanations if they do not provide an identifier.

Principal firms

The FCA notes that confusion has arisen around identifying principal firms, appointed representatives (AR), and tied agents in transaction reports. The FCA reiterates that, for transaction reporting purposes, it views an AR as its principal firm and so, when a transaction is executed by an AR for a principal firm that is subject to transaction reporting obligations, it is the principal firm that should be identified in the applicable fields of the transaction report. Due to ongoing issues with the level of care given by principal firms into overseeing their ARs, the FCA emphasises that principal firms are responsible for ensuring that their transaction reports are complete and accurate and for implementing adequate systems and controls framework to identify potential data quality issues.

Branch reporting

UK branches of third-country investment firms appear to be taking a range of approaches to determining when they are executing. The FCA clarifies that firms should not determine their reporting obligations based on the geographic location of a trader alone. Firms should also take into account factors such as the location(s) of the branch that received the order from the client, the branch that oversaw the individual responsible for making the investment and execution decisions, and the branch whose membership was used for executing transactions on a trading venue.

The FCA also expects UK branches of third-country investment firms to report if the firm is a MiFID investment firm so that the FCA can distinguish the reports they submit from those submitted by trading venues for transactions executed on their platforms by third-country firms.

Other common transaction reporting issues

• Misuse of ‘INTC’ reporting convention, eg, reporting an order from one client executed in multiple fills, to signal internal trading accounts, or failing to report both the market and client side of a transaction;
• Some trading venues have sought to pass their responsibility onto their members for the quality of the transaction reports the venues are required to submit. The FCA reminds venues that they should have robust processes in place to ensure the timely receipt of information from members necessary for them to submit complete and accurate transaction reports.
• Some firms continue to report a market identifier code when they transmit an order to an executing broker, who in turn executes the transaction on a trading venue. However, the venue (Field 36, RTS 22) should be populated ‘XOFF’ by investment firms who are in a chain and who do not access the venue directly (see Section 5.4.2 of the ESMA Guidelines on transaction reporting).
• For transactions executed in financial instruments that are not admitted to trading or traded on a trading venue (eg, CFDs), the instrument full name reported should contain a clear description of the financial instrument traded (eg, Vodafone CFD).

Instrument reference data

Trading venue and SI systems and controls

The FCA reminds trading venues and systematic internalisers (SIs) that they should have arrangements in place to enable them to identify incomplete or inaccurate instrument reference data and that data is being submitted in line with RTS 23 and in accordance with ESMA guidelines and Q&As. The FCA’s MDP system provides feedback for each reference data file received and firms should have procedures in place to review feedback files, including any warning messages received, which notify the submitting entity that its record differs from the master record used to validate transaction reports. These procedures should include investigating why records or files have been rejected. Submitting entities should not amend their reference data to match the master record before confirming its accuracy.

Where a trading venue or SI identifies incomplete or inaccurate instrument reference data in its submissions, the FCA expects to be notified promptly via the submission of an instrument reference data errors and omission notification form and corrected data should be submitted without delay.

Systematic internalisers

SIs should only report instrument reference data for instruments (i) in which they are an SI and (ii) that are reportable under Article 26(2)(b) or (c) of UK MiFIR. Some SIs incorrectly report instruments outside of these parameters.

Other instrument reference data issues

• For reporting instrument reference data under UK MiFIR, ISO 10962 CFI codes issued by the relevant National Numbering Agency should be used.
• Trading venues and SIs should only populate the issuer or operator of the trading venue (Field 5, RTS 23) with their own LEI when they create or issue the financial instrument.
• The termination date (Field 12, RTS 23) should be populated with the date and time the instrument is expected to cease trading. This date should be earlier than or equal to the maturity date (Field 15, RTS 23) or expiry date (Field 24, RTS 23), where applicable.
• Some trading venues have submitted data for instruments that are not commodity derivatives with the commodities or emission allowance derivative indicator (Field 4, RTS 23) populated ‘TRUE’. This can cause investment firms to receive a CON-460 transaction reporting validation error for failing to populate the commodity derivative indicator. In these cases, the FCA has identified good practice from investment firms who contact the trading venue on which the transaction was executed to confirm if the data is accurate.