19.III.2.3.2 Price formation

Price formation is also relevant for the degree of EU equity pre- and post-trade transparency regulation. The type of financial instrument is one aspect that is relevant for price formation. Whereas for equity instruments pre- and post-trade data can be a good indicator of liquidity, pricing in non-equity instruments is determined by factors beyond current and completed transactions, such as macroeconomic conditions (in particular for government bonds), credit risk and duration (e.g. maturity date of a bond). Consequently, although not entirely uncontroversial, the EU decided only to impose pre- and post-trade transparency rules for shares under MiFID I. The EU changed its perspective from MiFID I to MiFID II. CESR (predecessor of ESMA) noted that certain equity-like instruments, being – depositary receipts, ETFs, and certificates, have many characteristics like shares, including in terms of liquidity, structure, and the types of investors. CESR believed it would therefore be beneficial to require these equity-like instruments to meet the same pre- and post-trade transparency requirements as shares. The EU has adopted the same view as CESR under MiFID II.

Price formation also depends on where a financial instrument is traded. The price formation dynamics as to the trading location of financial instruments is open for debate, although some consensus exists when it comes to RMs and MTFs. Exchanges (i.e. RMs) have traditionally had large pools of liquidity and so are generally considered to contribute to effective price formation through the large amount of trading activity that exchanges (RMs) facilitate. This perspective is also apparent in the EU, since RMs have from the ISD to MiFID II been required to publish a high level of pre- and post-trade transparency (whether under national law or EU regulation). The same is true for MTFs. MTFs represent the same organised trading functionality as RMs. In addition, although MTFs are characterised with lower trading activity compared to RMs, MTFs have continually gained market share. From a price formation perspective, it is therefore understandable that MTF equity transparency rules have been relatively uncontroversial within the EU. Where the shoe pinches is trading activity outside RMs and MTFs. There is evidence that lower trading activity is still relevant for price formation. Within the EU this observation has raised complex debates, in particular concerning the merits of equity pre-trade versus post-trade trade transparency regulation. In a nutshell, the EU opinion is that – in order to support price formation – equity post-trade transparency is also crucial outside RMs and MTFs. There is no such EU consensus when it comes to pre-trade transparency outside RMs and MTFs.

Another aspect relevant for the price formation of a financial instrument is the trading system (see also paragraph 2.2 above). There are multiple trading systems through which a financial instrument can be traded. The equity trading systems for RMs and MTFs under MiFID II are in short order-driven markets, quote-driven markets, periodic auctions, request-for-quote markets, and hybrid markets. Although not officially a MiFID II ‘trading system’, SIs are mostly similar to the quote-driven markets deployed by RMs and MTFs. From the ISD to MiFID II, in the opinion of the EU, equity pre-trade transparency requirements needed to be calibrated to the trading system used. Opinions have differed as to what pre-trade data needs to be displayed for each respective system (e.g. so-called frequent batch auctions (a type of periodic auction) and the SI regime), but there has been agreement that calibration is necessary. The same is not true for the EU equity post-trade transparency requirements. From the ISD to MiFID II there has been no calibration of equity post-trade transparency requirements to the underlying trading system. The EU perspective is that the ‘optimal degree’ of equity post-trade transparency is not determined by the underlying trading systems. The EU reflects the perspective that completed trades (i.e. post-trade) are more or less the same. In view of the EU, trading systems have no – or at least too limited – impact on the completed trades to introduce calibrated EU equity post-trade transparency requirements.