5.II.4.4 Background

A main concern of the MiFID I review were broker crossing networks.1 Broker crossing networks fell outside the scope of the RM/MTF classification, since broker crossing networks brought together buying and selling interests in a discretionary way (in accordance with permissions of the client).2 Broker crossing networks therefore were regulated as investment firms operating outside an RM or MTF. In effect, no MiFID I pre-trade transparency rules applied to broker crossing networks (as well as other RM/MTF rules concerning access and surveillance), unless the broker crossing network qualified as an SI or the client limit order display-rule applied. Concerns arose about broker crossing networks in relation to price formation, unclarity for clients on the functioning of the network, and the level playing field among different trading platforms.3 Contrarily, proponents of broker crossing networks argued that the percentage of broker crossing networks was relatively small,4 post-trade transparency and other MiFID I rules applied, and investors were offered benefits, such as lower execution costs.5

During the MiFID I review, CESR was more supportive of the view to regulate broker crossing networks. CESR proposed a new regulatory regime as a response to broker crossing networks. CESR recommended bespoke requirements, such as details on access to the system and more accurate post-trade information.6 In the context of pre-trade transparency, CESR recommended that once a broker crossing network reached a defined limit, the system would be required to become an MTF. The broker crossing network would accordingly be required to become an MTF and comply with the applicable rules, including on pre-trade transparency.7 A large number of respondents to the CESR consultation agreed with the bespoke requirements for broker crossing networks.8 There were divergent view on the proposal to place a limit (threshold) on broker crossing networks to convert into an MTF. Some favoured the proposal, whereas other noted that broker crossing networks – in particular their ability to have a discretionary system – were fundamentally different than the business of an MTF.9

The Commission took it a few steps further by proposing to create a new-sub regime for broker crossing systems alongside RMs, MTFs, and SIs. The new-sub regime for broker crossing networks would fall within the broader category of a trading venue, that is – the ‘Organised Trading Facility’ (OTF).10 The Commission proposed that the OTF would apply to both equity and non-equity instruments. Reflecting CESR’s recommendations, the Commission proposed bespoke requirements to apply to OTF, such as enhanced post-trade data. No pre-trade transparency rules for the OTF were proposed at this stage.11 The Commission did not propose a limit (threshold) for broker crossing networks to be converted into an MTF (as CESR suggested). Instead, the Commission proposed to clarify that ‘if orders were entered into a matching system not only by the operator, but also by a third party, this would transform the system into an MTF’ (emphasis added).12 As a consequence, the pre-trade transparency requirements applicable to MTFs would apply to these systems.

Responses to the Commission’s consultation were overall hostile. Broker crossing networks argued that the new OTF classification had the danger of proliferation of different OTF venues (fragmentation) and encompassed a lack of flexibility.13 RMs and MTFs questioned whether a new category was the way of dealing with trading outside RMs and MTFs (including broker crossing networks). It was questioned why there was no focus on the existing MiFID I classifications of RMs, MTFs, and SIs to capture OTC trading.14

Despite the market criticism, the Commission retained the OTF-category in the MiFID II proposal. However, the sub-set of rules for broker crossing networks present in the consultation was removed. Instead, the Commission noted that the OTF itself would include broker crossing systems.15 The Commission used the term broker crossing networks here in a narrow sense, that is – limited to agency crossing (not: internalisation).16 The Commission also wanted to use the OTF for other regulatory purposes, that is – the OTF would also encompass systems eligible for trading clearing-eligible and sufficiently liquid derivatives.17 The aim of using OTFs as a platform for derivatives was a part of a G20 requirement. Following the financial crisis G20 members decided to improve transparency and oversight of OTC derivatives markets.18 The Commission believed the OTF could be a means to do so.

Hence, the Commission introduced the OTF to solve two matters at once: 1) the regulation of broker crossing networks (equity); and 2) to improve transparency of OTC-derivatives (non-equity). The dual approach was also reflected in the Commission’s OTF-design. First, OTFs would apply to both equity- and non-equity instruments. Second, and in deviation from its consultation position, the Commission proposed the OTF to be subject to pre- and post-trade transparency rules. Third, and finally, OTFs would have a distinctive feature compared to RMs and MTFs, that is - OTFs would be permitted to offer discretionary trading.19 Due to the discretionary nature of the OTF, rules of conduct were proposed to avoid conflicts of interest (e.g. best execution-rules were proposed). The discretionary element of the OTF was designed to reflect the nature of equity trading in broker crossing systems, as well as the illiquid and discretionary nature of trading derivatives.20

The European Parliament disagreed with the Commission’s proposal to address equity broker crossing networks through the design of the OTF. The European Parliament limited the scope of the OTF to non-equity instruments only.21 In effect, the European Parliament wanted to remove the possibility of OTFs to capture equity broker crossing systems engaged in agency crossing. The rationale behind the European Parliament’s limitation, among other things, was to protect the quality of price formation in the equity markets.22 Given their discretionary nature, the OTF could make an investment decision itself, instead of leaving it entirely to the investor. The European Parliament feared that OTFs could therefore harm the quality of pre-trade data in the equity markets.23 The European Parliament proposed to address equity broker crossing systems through limiting the amount of OTC-trading in general. In view of the European Parliament, OTC equity trading (including broker crossing systems) would in principle be prohibited to take place outside RMs, MTFs, and SIs. ‘In principle’, since OTC equity trading (including broker crossing systems) would be permissible only where four cumulative conditions would be met. The four conditions were: (i) a SI was not available; (ii) the transaction was ad hoc and irregular; (iii) the transaction was between eligible counterparties and professional clients; and (iv) the transaction was large in scale.24

The OTF-design was very controversial in the Council. The Council was divided in two camps. One side favoured the introduction of the OTF in general (both for equity and non-equity), but wanted to make the OTF rules less strict. The other side wanted to make the OTF rules stricter or perhaps even remove this new trading venue and ensure that organised trading could only take place on RMs, MTFs, and SIs (the latter reflecting the European Parliament’s position).25 The Council finally limited the OTF category to non-equity instruments, a position that was a compromise.26 In return for the limitation to non-equity, the OTF would be permitted to engage in so-called matched principal trading.27 The compromise position of the Council meant that OTFs would not capture equity broker crossing systems under MiFID II. Instead, the Council suggested to require investment firms operating internal matching systems in agency crossing to convert into MTFs.28 The position of the Council meant that equity broker crossing networks engaged in agency crossing would be required to become authorized as an MTF and accordingly comply with the MTF pre-trade transparency requirements.

The complex negotiations on equity broker crossing networks are evident in the final MiFID II text. MiFID II does not use the concept of an OTF for equity broker crossing networks. MiFID II limits the OTF to non-equity instruments only. Rather, MiFID II addresses equity broker crossing networks, among other things,29 through the requirement for (a) internal matching systems that (b) executing client orders in equity instruments (c) on a multilateral basis to (d) become authorized as an MTF. MiFID II intends to ensure that any trading system in financial systems, ‘such as broker crossing networks, are properly regulated’. The wording ‘properly regulated’ refers in this context to being authorised as an RM or MTF.30 The MiFID II requirement, that is - for multilateral internal matching systems executing client orders in equity instruments to authorise as an MTF, is part of the MiFID II ambition to ensure broker crossing networks are properly regulated.31 The situation of MiFID II is a substantial change compared to MiFID I. Under MiFID I equity broker crossing networks fell outside the regulatory classification of RMs and MTFs given the discretionary nature of broker crossing network.