2.1.2.3 Matched principal trading

52. 1) Introduction -MiFID II adds to the concept of “executing orders” the concept of “matched principal trading”, which entails “a transaction where the facilitator [the investment firm] interposes itself between the buyer and the seller to the transaction in such a way that it is never exposed to market risk throughout the execution of the transaction, with both sides executed simultaneously, and where the transaction is concluded at a price where the facilitator makes no profit or loss, other than a previously disclosed commission, fee or charge for the transaction”.1 Matched principal trading was, under MiFID I only part of the permission to deal on own account, but with the introduction of MiFID II has also been explicitly included in the services of executing client orders.2 The European legislator stated that “dealing on own account when executing client orders should include firms executing orders from different clients by matching them on a matched principal basis (back-to-back trading), which should be regarded as acting as principal and should be subject to the provisions of this Directive covering both the execution of orders on behalf of clients and dealing on own account”.3

53. 2) Relevant risks - By adding this definition to the investment service of executing of orders, the European legislator accepts that an investment firm performing the activity of execution of orders on behalf of clients is not exposed to market risk for the financial instruments involved in the transaction. As both sides of the transaction should be concluded simultaneously, the economic impact on the investment firm’s balance sheet should be negligible, aside from a P&L impact of the fee charged for this transaction. What is relevant in this case is the distinction between transactions concluded through a central clearing system and transactions concluded OTC, as discussed earlier. Transactions concluded through a central clearing system should not incur any additional risks for the investment firms, whereas transactions concluded OTC by the investment firm might incur additional risks. In the case of an OTC transaction an issue might occur during settlement which prevents the settlement from concluding successfully. The question, however, is whether this is an actual risk faced by a matched principal trader, or whether the definition of matched principal trading explicitly excludes this. Since the definition of matched principal trading requires that both sides of the transaction conclude simultaneously, a situation where this does not occur would mean the investment firm is not a matched principal trader. It would then fall within the category of investment firms dealing on own account discussed below.

54. This discussion above in Paragraph 53 is limited to the possible market risks that investment firm is exposed to. The European legislator tried to make explicit that a matched principal trader is not exposed to market risk, but this might only be true if both sides of the transaction are executed by the investment firm simultaneously. As long as the financial instrument being traded will not be in possession of the investment firm, the market risk is borne by the clients of the investment firm who own the financial instrument (the seller of the financial instrument will retain the market risk until executing of the order, upon which the market risk of the financial instrument will transfer to the buyer of the financial instrument). However, if the investment firm gets possession of the financial instrument (even if just for a few seconds before being able to transfer it to the buying client), the investment firm will be fully subject to the market risk of that financial instrument for that (possibly short) time period.

55. This example also illustrates the most significant prudential risk that a matched principal trader is exposed to: operational risk. The process of order execution and the need of simultaneously concluding both sides of the transaction places great emphasis on the need for an adequate operational process. Any errors in that process will not only leave the investment firm from being liable to its clients, but it will also subject the investment firm to the market risk of the financial instrument being traded. Although a matched principal trader has a risk profile similar to that of an investment firm executing orders, there are additional operational risks and possible market risks associated with the matched principal trading activity.

56. 3) Framework for assessing risks – for a matched principal trading firm, the risks and consequences thereof for the risk profile are similar to a firm executing orders. Similarly to executing orders, when applying a framework to assess the risk profile of this matched principal trader, the most relevant dimension these types of investment firms is ‘operational risk’.