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WFE Focus April 2011
OTC trading and broker/dealer crossing networks in European equity markets
Peter Gomber
Chair of e-Finance, University of Frankfurt
Axel Pierron
Senior Vice President Banking, Securities & Investments Celent

In the context of the MiFID Review, the Chair of e-Finance at Goethe University (Prof. Peter Gomber), Frankfurt and Celent (Axel Pierron) jointly published a research report entitled ‘MiFID: Spirit and Reality of a European Financial Markets Directive’. The report (available at: analyses the status quo of European equity markets from a legal, economic and business perspective. It draws on a broad range of resources including trading data, interviews, and an analysis of business models. The investigations lead to the following key conclusions specifically concerning OTC trading and the role of Broker/Dealer Crossing Networks in European equity markets:

MiFID’s key objectives are market efficiency, market integrity, and fairness. The key idea of MiFID is to establish a comprehensive regulatory regime governing trading in financial instruments irrespective of the trading methods used to conclude those transactions. Recognizing innovations in financial products, services, and specifically new trading methods and new trading technologies alongside regulated markets in the 15 years since the implementation of the original ISD, the Directive’s aim was to establish a regime that assures the integrity and efficiency of the financial system in general, and high execution quality of investors’ transactions and the transparency and efficiency of the price discovery process in particular. By defining a new trading venue classification (i.e., regulated markets, multilateral trading facilities, and systematic internalizers) and by enabling these venues to compete on a level playing field in terms of fees, services, and technology, the Directive tries to encourage innovation, reduce explicit and implicit trading costs for investors, and reduce the cost of capital for issuers.

However in practice, the OTC side of the market has not been touched by the MiFID regulation. Now three years after the implementation of MiFID, the reality of European markets reveals that the competition between regulated markets and the newly emerged MTFs works in favor of investors and has led to the desired effects in terms of technology and trading model innovations, service competition, significant fee reductions, and improved market quality in terms of reduced spreads and deeper order books. However, there are only a few investment firms that are registered as systematic internalizers, and transactions carried out on an OTC basis represent a significant (around 40%) and stable part of the overall trading volume in the European equity market. These facts raise some important questions.

In reality, trading activity currently reported as OTC activity is very different from the original MiFID intention. MiFID characterizes OTC transactions in Recital 53 as transactions that cumulatively fulfill the requirements of being ad hoc and irregular, carried out with wholesale counterparties, above standard market size, and conducted outside systems used for systematic internalization. The analysis of OTC data in this study reveals that currently the majority of OTC transactions are not larger but smaller than standard market size. If—as most market participants state—the minimization of market impact is the central motivation for OTC trading, one should expect that most OTC trades would face market impact if concluded on the reference market. However, the analysis reveals that most OTC trades would face no market impact. The share of OTC trades that would face no market impact increased from 68% in 2008 to 80% in 2010 for high liquids and from 58% in 2008 to 66% in 2010 for less liquids. A significant share of OTC trades are rather small and would not face market impact, and the structural differences between OTC trading and primary market trades are overestimated in the public discussion.

Implementation of trading technologies has reinforced the sensitivity of market data. The fragmentation of venues driven by the opening of venue competition due to MiFID has accelerated the adoption of trading technology from order management systems to algos and SORS. This technologies have changed the way trading is conducted in the European cash equity market. Not only has it driven a decrease of order sizes but it has also made market data, pre- and post-trade, more crucial to market participants, because this information is necessary for this computer-based trading to operate. Therefore, investors are in a situation where they need to capture relevant market data as close to real time as possible, but, at the same time, are looking for opportunities to hide their own trading strategy and pattern. This concern about information leakage is driving an increase of order execution in the dark side of the market, be it through dark pools, crossing networks, or OTC. However, due to technology implementation cost and complex post-trade infrastructure, the vast majority of buy side volume (88%) is in fact handled by broker/dealers that are de facto in a situation to favor their own dark venues, the crossing networks, or phone brokerage (OTC) at the expense of dark pools.

Broker/Dealer Crossing Networks are a positive evolution of the OTC market, but a vast majority of their operations should be regulated. Broker/dealers have developed matching engines to electronify their OTC activities that were mostly conducted over the phone in the past. This is a clear improvement for the industry as whole since it will decrease the likelihood of mismanaged orders, improve the post-trade processing and reporting, etc. However, BDCNs do not provide a unique model of execution. In reality, BDCN operations could qualify for all three venue classifications created by MiFID. Therefore the fact that BDCNs are currently considered OTC transactions is, to a certain extent, a breach of competition since they provide mostly the same services as the regulated venues without the regulatory burden, be it pre-trade transparency or the implementation of “waivers” for dark pool operations.

Reliance on OTC market operations should be closely supervised. The current level of transactions that are conducted OTC pose a real threat to the order-driven model of the European cash equity market. The situation is even more acute with the development of BDCNs that could capture more market share from the regulated trading venues (regulated markets, MTFs, SI). With negotiation happening in the OTC space, the price discovery mechanism happening on the “lit” market could be severely impacted, pushing the equity market to become a quote-driven market very similar to the structure in place in commoditized OTC asset classes that are the fixed income and spot FX markets.

The development of BDCNs creates second class investors. While MiFID has imposed non-discretionary access rules to the various regulated venues, BDCNs are allowed to provide access to selected customers across the various market participant types (traditional buy side, other sell side, hedge funds, etc.). Therefore, access to this liquidity pool is not set on a fair basis, and some market participants that cannot afford or do not wish to become customers of the BDCNs are very likely to become second class investors unable to access the whole liquidity pool available in the market. This situation is even more acute today since numerous BDCNs are becoming linked to one another to create a cloud of crossing networks that will deepen their pool of liquidity and increase the likelihood of execution.

The significant level of OTC activity and the development of BDCNs create some serious market surveillance concerns. Broker/dealers are a very regulated community, and they have to conduct some significant customer activities and order surveillance operations. However, they do not conduct any venue surveillance activity, as regulated trading venues do, and since they do not provide any pre-trade transparency either, the opportunity for an investor to conduct market abuse and market manipulation activities across the various untransparent and unmonitored liquidity pools has increased significantly. This concern should not be minimized because the current fragmented nature of the European regulatory and surveillance infrastructure requires the commitment of every single trading venue operator to minimize opportunities of misconduct and maximize the likelihood of spotting market abuse activity.

The key MiFID principle of functional regulation should not be touched. Obviously OTC trades are different from what MiFID envisages them to be, and therefore (i) the extent and profile of OTC reality has to be reflected in depth in a potential MiFID amendment, and (ii) the intention to protect large orders against market impact has to be cross-checked against the reality of trading opportunities provided in public, transparent markets and has to be adequately reflected in new metrics and regulatory parameters. In this discussion, the regulatory handling of BDCNs is a central component. It is undisputed that these crossing networks provide value to customers, and that there is a demand for that service. However, because these execution mechanisms are providing both a multilateral matching of client orders against each other and deal on their own account by executing client orders, they should be classified either as MTFs or as SIs and should fulfill the same regulatory obligations like these MiFID trading venues in terms of transparency, access, and venue surveillance. Given that functional regulation is a key concept of MiFID, the regulatory classification of BDCNs should be based on a functional perspective only. The implementation of a threshold approach for BDCNs currently discussed in the context of the MiFID review would enable these execution venues to leverage their flexibility and adaptability for regulatory arbitrage and would put other MiFID trading venues (e.g., smaller MTFs) that have to fulfill the full range of requirements at a significant competitive disadvantage.

About Peter Gomber

Professor Peter Gomber holds the chair of e-Finance at the Faculty of Economics and Business Administration, University of Frankfurt. He is, in addition, co-chair and member of the board of the E-Finance Lab, a cooperation between the Universities of Frankfurt and Darmstadt and a network of industry partners from financial services. In the E-Finance Lab, he manages the research layer “Electronic Financial Markets and Market Infrastructures”. He has published numerous articles in international journals and has been awarded the Reuters Innovation Award in 2000, the University Award of Deutsches Aktieninstitut (DAI) in 1999, the IBM SUR Grant in 2007 and several best paper awards at international research conferences.

Before assuming his professorship at the University of Frankfurt, Dr. Gomber worked as Director and Head of Market Development Cash Market in the Trading & Clearing Services Division of Deutsche Börse AG.  He has been a member of the Exchange Council of the Frankfurt Stock Exchange (FSE) since 2011 and is also a member of the Academic Committee of the Deutsches Aktieninstitut (DAI).

About Axel Pierron

Axel Pierron, based in the firm’s Paris office,  is a Senior Vice President for Celent’s India research group. Mr. Pierron’s expertise lies in electronic bond trading, derivatives and FX markets, market infrastructure, trade finance, and claim management automation.

Mr. Pierron is quoted regularly in the media, including the Financial Times, Reuters, Les Echos, Le Monde, CNBC, BBC, Financial News, France 2, Daily Telegraph, and European Banker. He is a frequent speaker on technology’s impact on strategy and market organization. Mr. Pierron was a member of the Mission Ecoter within the French Senate and of the Association pour le commerce et les services en ligne (ACSEL).

Before joining Celent, Mr. Pierron was an Internet research analyst for BNP Paribas, where he conducted a variety of market research and projects in fields such as e-finance, global B2B operations, knowledge management, and CRM. He was a member of several strategic Internet units within BNP Paribas, including those focused on financial markets.

Previously, Mr. Pierron was an internal auditor for Leclerc, the second largest supermarket chain in France. His duties there included management of an EDI implementation project.

Mr. Pierron holds an MA in financial markets from the CERAM business school in Nice, France. He is fluent in English and French and proficient in German.

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