19.III.2.1 Market microstructure

Market microstructure refers to the process and outcomes of exchanging financial instruments under explicit trading rules. If permitted by EU regulation, trading can take place through the systems of an RM or MTF, but also outside such venues (e.g. SIs). The research examined several dimensions of a market microstructure, in particular (i) the trading process (e.g. order-driven versus a quote-driven market), (ii) liquidity, (iii) the nature of trading platform (e.g. risk taking or not), and (iv) the size of a trading platform. All four dimensions of the market microstructure have determined the degree of EU equity pre-trade transparency regulation, whereas only several (not: all) dimensions have been relevant for the amount of EU equity post-trade transparency regulation. Market philosophies also play an important role here. The following examples support this conclusion:

The trading process, liquidity, and the nature and size of a trading platform determine the degree of EU equity pre-trade transparency regulation. For example, there was a lot of debate at the EU level whether or not to introduce equity pre-trade transparency rules for SIs under MiFID I. Supporters of the market-shaping philosophy argued that internalisation encompassed risks for price formation and accordingly equity pre-trade transparency rules were necessary. By contrast, the market-led philosophy emphasized position risks of internalisation (i.e. execute client orders by trading on own account) and claimed that post-trade transparency rules would be sufficient. The compromise under MiFID I was that where internalisation (nature) was systematic, frequent, and regular (size) equity pre-trade transparency rules applied, provided certain conditions were met.1 Concerning SIs, MiFID II adds a quantitative element.2 The effect of MiFID II is that, besides the nature of the activity (internalisation), size has become of greater importance in drafting EU equity pre-trade transparency regulation. Naturally, liquidity is also important, because when trading becomes more liquid, the trading process naturally evolves towards a market microstructure where supply and demand are matched without a specific risk-taking intermediary that provides liquidity by trading on own account (e.g. an order-driven market). By contrast, when liquidity shrinks, a specific risk-taking intermediary, such as a market maker (e.g. a quote-driven market), becomes more important.3 The complexity for the EU is finding political agreement on the right degree of equity pre-trade transparency regulation for the market microstructure in question.

Liquidity is also a relevant element for EU equity post-trade transparency regulation. The EU has traditionally upheld the opinion that - where liquidity is provided through large transactions - deferral of equity post-trade data publication is legitimate, since it enables to protect against inventory risk (i.e. protect against other market participants taking positions at the detriment of the market participant providing liquidity).4 It is controversial, however, how long the possibilities for deferral should be.5 The trading process, nature and size of the venue play a less prominent role in terms of EU equity post-trade transparency regulation. Under the ISD a minimum standard of post-trade data publication was seen as necessary for RMs. Alternative trading systems and order internalising systems were not subject to ISD transparency rules.6 The perspective changed under MiFID I, where the EU covered equity post-trade transparency rules for RMs and MTFs and investment firms operating outside such venues (including SIs). Despite the differences in nature and size of these venues, MiFID I overall applied the same equity post-trade transparency rules to RMs, MTFs, and investment firms operating outside such venues.7 A similar perspective is apparent under MiFID II.8 Although uncertain, the MiFID II ESMA Review suggests that this approach will not change in the future. The reason that less dimensions of a market microstructure are relevant for EU equity post-trade transparency regulation is because there is less diversity in terms of concluding a transaction (post-trade) compared to the diverse range of activities possible for a potential transaction (pre-trade) (e.g. agency crossing, internalisation, and so forth).