Markets View – Easter 2023

As the seasons shift and the regulatory landscape for financial markets evolves, our latest edition of Markets View brings you up to speed on several key developments. This time, we start with ESMA's Final Opinion on the trading venue perimeter. We'll also tackle the LME's nickel market saga with a focus on the recent FCA and BOE statements, discuss the potential impact of the MiFID2 inducements ban, and (cautiously) celebrate the recent agreement between the FCA and ESMA, enabling UK benchmark administrators to operate in the EU. Lastly, we'll explore ICE's implementation of the EU Market Correction Mechanism and the launch of a parallel market as "insurance". So, grab your cup of coffee and let's dive in!

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

ESMA Opinion sheds (some) light on the trading venue perimeter and multilateral concept

ESMA recently published its Final Opinion on the trading venue perimeter, clarifying (kind of) when systems and facilities qualify as "multilateral" and therefore need EU authorisation as an MTF. The concern was that some systems / facilities were side-stepping the regulatory perimeter, but ESMA's previous approach was relatively expansive and not technology-neutral.

So, what's changed?

Good news - the Opinion has evolved since the consultation draft. However, it continues to be a complex area where the boundary is grey. The main takeaway is that it's not about form or technology, but functionality that determines the perimeter, which is determined by the four cumulative factors below.

1. It is a system or facility. This does not include general purpose communication systems (e.g., BT lines) or outsourced software providers.

2. There are multiple third-party buying and selling interests. The Opinion maintains that a single liquidity provider system operated by a third party is not necessarily bilateral on the grounds of Robeco v Stichting (which held that one-to-many interactions were multilateral).However, ESMA has backed off from relying too heavily on this case, which is a big win, as Robeco was very fact specific and decided under text where there was no OTF concept.

3. Those trading interests are able to interact. Although a contract does not need to be concluded via the system, the price, quantity or other essential terms must be agreed via the system. This interpretation appears to be based on derivatives markets (and the fact that terms are concluded outside the system(s) in some instances) in a manner that is more aligned with the MiFID2 MTF and OTF definitions, which require interaction "in a way that results in a contract".

4. Trading interests need to be in financial instruments.

The interaction criterion is still tricky for systems with no visibility of the end execution or terms they've facilitated. ESMA is putting responsibility on systems pre-arranging transactions, given these transactions are "formalised on their venue" and should be "carried out in accordance with the rules". Not all systems will be aware of this, though, which may prevent some innovators from being able to launch services.

Wondering who's in scope? Here's a quick rundown.

Excluded from the multilateral concept:

• Systematic Internalisers (SI) in bilateral systems where SIs deal on risk and entities aren't able to interact with each other on the basis they have other permissions as an investment firm for dealing.
• Information systems / bulletin boards not allowing communication or negotiation (or execution/ bringing together in the system), including notification of a possible match in the system (which feels fairly restrictive).
• Basic order management systems without additional functionality that allows trading interests to interact.
• Pricing or other information tools.
• Pre-arranged transactions formalised on a trading venue for clearing.

Included in the multilateral concept:

• Transactions reported to a trading venue on the basis that they are deemed to take place on venue.
• Systems that pre-arrange transactions negotiated on a multilateral basis, which are considered an extension of the system where they are ultimately negotiated but need to benefit from a pre-trade transparency waiver. Pre-arrangers may also require investment firm authorisation.
• Where the system sets the rules (software provider driven) rather than the investment firm.

Over to the NCAs

An Opinion is binding guidance for NCAs and ESMA expects NCAs to require firms to swiftly apply for authorisation as a trading venue where necessary.

Nickel For Your Thoughts: FCA and BOE statements on LME's market freeze

The FCA and Bank of England (BOE) have chimed in with follow-up statements on the London Metal Exchange's (LME) decision to suspend trading on its nickel market back in March 2022, stressing that the supervisory work undertaken (and still ongoing) had raised concerns and further action is being taken.

The FCA's statement urges LME to "consider carefully how the events of March 2022 should shape its future approach on market structure". The regulator emphasises the role of transparency in facilitating effective risk management alongside certain changes that have been implemented in its control framework. These changes were guided by the recommendations of an external review commissioned by LME and LME Clear. The FCA will continue to investigate and monitor the LME Board's oversight in driving necessary changes. In response, the LME states that it's taking "active steps" to improve nickel market liquidity, including resuming Asian hours nickel trading.

The BOE's statement confirms that a skilled person report, under section 166 of FSMA investigated the events leading to the nickel suspension. Additionally, LME Clear and the LME jointly commissioned an independent review into the factors that contributed to the market turmoil. According to the BOE, these reviews identified "several shortcomings across LME Clear's governance, management and risk management capabilities". However, the BOE welcomed LME Clear's commitment to publishing and executing it implementation plan (available here). As a next step, the BOE plans to appoint another skilled person to "independently monitor, assess and report to the Bank regularly on LME Clear's implementation progress against remedial actions". Stay tuned as we continue to follow the developments in the LME's nickel market saga (the "Nickelungenlied"?).

MiFID2 Inducements Ban Update: ETF boost and the road to retail empowerment

The EU's financial services chief has suggested that a sweeping EU-wide ban on inducements could pave the way for increased retail investment in exchange traded funds (ETFs), ultimately delivering better outcomes for consumers. As part of the European Commission's broader Retail Investment Strategy (RIS), now expected May 2023, the latest proposal seeks to ban inducements for MiFID2 non-independent advisory services. The RIS aims to enhance retail investors' access to financial markets, while maintaining investor protection.

As our readers may know, MiFID2 prohibits inducements for independent advice, but permits them for non-independent advice provided under specific conditions. However, a comprehensive ban may be on the cards, subject to ongoing negotiations within the EU.

Who stands to be affected by this potential ban?

Any firm offering non-independent investment advice to retail investors will clearly need to reassess the position if a ban were introduced, but the ban is also of note for (i) firms that manufacture products which are eventually offered via non-independent investment advice to retail investors as well as (ii) other firms in the distribution chain.

Behind the scenes: what's the buzz?

The European Commission's RIS aims to improve access for retail investors to financial markets, whilst at the same time ensuring investor protection. Based on speeches made by Commissioner McGuiness, the EU Commission appears to be strongly advocating a total ban, so the RIS (once published) may well include this proposal. There is, however, strong opposition from some European Parliament members and also certain swathes of industry. Interestingly, even where there is strong political opposition to a ban, there's a growing consensus that some fees, partially due to inducements, are excessively high and not 'value for money'. As a potential compromise, some form of value-for-money assessment, possibly via a methodology employed by manufacturers and distributors, might emerge as a "third way" between the status quo and an outright ban.

Given any total ban on inducement would likely ultimately require legislative change to MiFID2 provisions-requiring approval by the European Parliament and Council) it remains unclear whether, even if the European Commission proposes the ban, it would ultimately be implemented.

Benchmark Bridges Built: FCA and ESMA reach agreement on recognition of UK benchmark administrators in the EU

UK benchmark administrators will be able to operate within the EU following an agreement reached between the FCA and ESMA. As a reminder, following the UK's withdrawal from the EU and the end of the Brexit transition period, the UK Benchmark Regulations(UK BMR) has applied in the UK. UK firms involved in benchmark administration were required to submit an application to the FCA before 1 January 2020. But the transitional period for third country benchmarks was extended, initially from the end of 2019 to the end of 2022, and further extended to 31 December 2025 under the Financial Services Act 2021. As a result, third country administrators that want the use of their benchmarks by UK supervised entities to continue after this final date must apply to the FCA for approval via equivalence, recognition or endorsement before 31 December 2025.

The FCA and ESMA entered into two memorandums of understanding (MoUs):

1. Establishing a co-operation arrangement for the purposes of the UK BMR, facilitating efficient information exchange regarding EU critical and non-critical benchmarks provided by administrators of EU critical benchmarks supervised by ESMA; and

2. Recognising the UK benchmark administrators in the EU, aiming to: (i) to establish a cooperation arrangement under the EU Benchmark Regulations (EU BMR) for an efficient exchange of information; and (ii) confirm that UK law, regulation or administrative provisions do not hinder ESMA's supervisory functions under the EU BMR, while ensuring that there are no limits on the FCA's ability to exercise supervisory or investigatory powers under UK BMR for UK benchmark administrators seeking recognition in the EU.

Under the EU BMR, non-EU benchmark administrators seeking recognition in the EU must be supervised in their home jurisdiction and ESMA must first establish an MoU with the relevant non-EU authority as a prerequisite for ESMA grant recognition to that non-EU administrator.

ICE Takes the Plunge: Implementing the EU Market Correction Mechanism and price cap on TTF natural gas & parallel market launch

The Intercontinental Exchange, Inc (ICE) recently unveiled its plan to implement the EU Market Correction Mechanism Regulation (MCM Regulation) and related price cap on TTF natural gas derivatives. ICE Endex, which is the operator of the world's most liquid trading venue for TTF natural gas futures and options, updated its Rulebook to comply with the MCM Regulation, which took effect on 15 February 2023.

In brief, ICE Endex will prevent market participants from submitting orders to the exchange order book in TTF derivatives above the price cap when the correction mechanism is activated, unless one of the exemptions granted by the MCM Regulation applies. At the end of each trading day, ICE Endex publishes settlement prices for all contracts listed on the exchange. Prices will be determined to reflect the fair market value of TTF futures and option contracts. Consequently, settlement prices of TTF futures and options may deviate from the price cap when it doesn't reflect fair market value.

Circumventing the EU price gap, ICE launched a parallel market for TTF gas futures and options contracts on its London-based exchange on 20 February. This alternative market an "insurance option" for market participants if the EU's new gas market correction mechanism is at risk of being triggered, offering optionality in the event natural gas prices rises and the likelihood of activating the MCM price cap increases. To trigger the cap, the TTF month-ahead price would need to exceed EUR180/MWh for three working days and the month-ahead TTF price to be EUR35/MWh higher than a global LNG reference price at the same time - which is not currently a concern as the TTF month-ahead price sits well below that threshold at the time of publishing.

It's worth noting that regulators have cautioned that the price cap could prompt market participants to alter their trading activities by moving towards markets where it doesn't apply, such as over-the-counter trading and hubs other than the TTF.