Has ESMA Shaken Up the FX Platform World?
Posted by Colin Lambert. Last updated: April 8, 2024
With The Full FX View
A long-standing point of contention, or ambiguity, in FX markets has been what some in the industry view as the imbalance resulting from different regulatory treatment in the European Union of venues that ostensibly offer the same service. This may now be cleared up thanks to an Opinion published by the European Securities and Markets Authority (ESMA).
The problem stems from what constitutes a Multilateral (MTF) or Organised Trading Facility (OTF) in the EU, with several technology providers in the FX (and other) markets arguing they were not “in scope” of the regulation because they were mere technology providers and that trading was done on an RFQ or RFS basis. This has meant that some aggregation platforms in FX have operated alongside venues such as 360T and FXall, but have not had the regulatory burden of the latter two (and others).
ESMA has been pondering the “trading perimeter” as it calls it for some time and issued a Consultation paper in January 2022, the feedback from which, has informed the latest Opinion. It is noteworthy that the regulation does not, at this time, incorporate spot FX, however with an increasing number of platforms/aggregators targeting FX swaps, NDFs and options, a change in the landscape could have significant ramifications – not least in requiring smaller venues to undergo the cost and effort of registration.
In the Opinion, ESMA “acknowledges that there is a lack of a homogenous view of what should constitute a multilateral system, and consequently, what types of systems require authorisation as a trading venue”, and provides further guidance on what constitutes a multilateral system. It makes it clear (or at least as any ESMA paper can – there is still a lot of convoluted language and legalese), that any platform that brings together multiple buyers and sellers, who are able to interact and trade, is defined a multilateral system.
The Opinion states, “For an effective functioning of the MiFID II provisions, there must be clarity as to when a system or facility qualifies as a multilateral system. From the definition in Article 4(19) of MiFID II, four key aspects/criteria should be met, cumulatively, to be considered a multilateral system:
- a) it is a system or facility; and
- b) there are multiple third-party buying and selling interests; and
- c) those trading interests are able to interact; and,
- d) trading interests need to be in financial instruments.
For the first criteria, ESMA defines a system as technology-neutral with a set of rules that govern how third-party trading interests interact, including the matching, arranging and/or negotiation of trading interests. These rules or features could be contractual arrangements or standard procedures that shape and facilitate the interaction of third-party trading interests.
Rules in this context should not be understood to include the technical standard of message construction (e.g. XML) and/or the protocol which governs the technical exchange of messages, ESMA points out.
The second criteria cites “third-party” as “persons other than the system operator, that are brought together in a transaction”. In scope are also systems where two trading interests interact, provided they are brought together under the rules of a third-party operator. “This analysis refutes the argument that a system is deemed to be bilateral even where there is always the same participant on the one side of a transaction which executes the order from an investor,” states ESMA. “Considering such system as bilateral would negate the involvement of the system operator which runs the system as an independent operator in respect of the parties entering into the transactions. Therefore, having a single liquidity provider is not sufficient for the system to be considered bilateral.
“This would not include, for example, the use of a third-party provider as an outsourcing element of a firms’ IT capability,” it adds.
On the third criteria, ESMA says to be considered a multilateral system, not only the system has to have multiple third-party buying and selling interests, but also those trading interests must be able to interact in the system. “ESMA considers that for such interaction to occur, the system must not only allow the display of the different trading interests but also allow users to react to those trading interests, i.e. it should be possible to exchange information concerning those trading interests and match, arrange and/or negotiate essential terms of a transaction (for example instrument, price, quantity) with a view to conclude a transaction in those financial instruments,” the Opinion states.
It adds that the conclusion of a legally-binding contract is not a prerequisite for a firm to require to register. “Systems where trading interests can interact, where there is confirmation (or pre-arranging) of a transaction or where the essential terms have been (or can be) negotiated (for example price, quantity), would still require authorisation as a trading venue, even if some further contractual details are arranged outside of the system as is the case with many derivative contracts,” the Opinion states. “In such instances it cannot be argued that there is no interaction in between trading interests only because the final terms of the contractual agreement are concluded outside of the system or facility.”
The Full FX View
Putting aside the fact that there must be a place set aside in hell for people who have to read and understand ESMA publications (they must have done something very wrong!), this Opinion may have serious implications for the FX industry.
At a headline level, those firms aggregating liquidity that have previously argued they are just technology providers will no longer be able to make such a case – the paper makes clear that any multi-dealer system is in scope. This could mean a regulatory headache for smaller firms who have previously had an advantage in their lightness and nimbleness, which translated into lower costs.
Equally, these firms, who often have to spend more on their technology to remain competitive, may find their investment budgets are trimmed severely – if there is one thing we know it is that meeting regulatory demands is not cheap.
This should mean that those firms operating a regulated platform in the EU will find themselves more competitive – especially given how there is no implementation date on the ESMA Opinion, which means, according to experts, that it is “live” immediately. Of course, having said that, shifting clients from one venue to another has proven extremely difficult in the past, how will it be any different with an aggregator (unless the provider does not wish to be EU-regulated, which brings its own issues).
There is probably also food for thought in this Opinion for the single dealer platforms, especially those that allow other LPs onto their platform for the use of, for example, their algo execution clients. Some banks also operate quasi-ECNs where client-to-client matching is allowed, this too could come in scope of ESMA’s rules.
As with most regulation, FX is a likely side pocket to the real targets, securities and fixed income markets, but this could have implications, especially for those venues offering non-spot products. At face value this means a heavy lift for some firms, which could see their competitiveness eroded.
That said, this is a European regulation, so, after 40 pages of interminable repeats and convoluted language and legalese, ESMA closes with the observation that “judgement will always require a case-by-case assessment” – in other words, there is still plenty of room for interpretation by National Competent Authorities.
Overall though, if I were a technology provider of trading services, I would be looking closely at my business, as I would too if I were a client of such a firm.
Reinforcing this work, and given the complexity of the regulation, ESMA highlights three specific cases in its latest Opinion – two of which are technology providers and RFQ systems. On tech providers, it observes that information systems need not register, but that any venue with “a button where the intention to enter into a transaction can be confirmed” is genuine interaction and would require registration.
ESMA adds that it is the “functioning of the arrangement” that is the key to assess whether the activity requires registration, rather than the form of the arrangement or the technology used.
Execution management systems (EMS) are not considered to come in scope according to the Opinion, where users are only managing their only processes. It adds, however, that “irrespective of their “EMS” label, those systems which present additional features and a level of complexity that allow for the interaction of multiple third party buying and selling interests in financial instruments, thus combining all four criteria identifying a multilateral system, should be required to seek an authorisation as a trading venue”.
Where a software vendor has embedded a number of rules that govern the interaction of trading and does not allow investment firms to set their own rules, ESMA says the software vendor would be operating a multilateral system. “An EMS which would allow for firms to gather quotes from multiple players, allowing these trading interests to interact within the system with other clients’ orders could be, depending on the specifics, a multilateral system and subject to the authorisation as a trading venue,” it states.
On RFQ systems, ESMA observes that some stakeholders “may have diverging interpretations” of what this actually constitutes, especially around multilateral and bilateral systems. The Opinion notes that even so-called “RFQ-to-one” mechanisms, where a price is requested of just one LP, should be considered a multilateral system if it is possible to get quotes from additional dealers on the same platform.
This brings single-dealer platforms into play, on which ESMA says that these remain out of scope as long as the platform owner, presumably a bank in FX, sets the rules of engagement and acts similar to a systematic internaliser (SI).
