The Ultimate Risk-Reward: To MTF or Not?

Smaller technology providers are facing a tough choice as they attempt to adhere to UK and EU rules defining what constitutes a trading platform: make a disproportionately large investment or inhabit a regulatory grey zone with potentially significant consequences. Eva Szalay reports.

Seven months after the FCA’s new guidance came into force and a bit over a year since ESMA published its own version of trading platform perimeters, market participants in currencies and interest rate markets are split on what should happen next. One camp, mostly larger service providers and whose participants have already made the significant investment to become a regulated trading venue, is arguing that the FCA and ESMA should clamp down on the “conspiracy of silence” around non-compliance, as one source described the situation to The Full FX, to level the playing field.

“Yes, it will hurt if they catch us, but just think how tasty that chicken is”

The other side, however, is firmly convinced that for competition to survive, smaller companies have to be able to come up with solutions that exempt them from having to make the millions of pounds of commitment that adherence requires. “Technology companies are facing a stark choice,” says Damon Batten, head of capital markets and Hong Kong at financial services regulatory consultancy Bovill, adding there has been a noticeable uptick in interest in the issue recently from technology companies, with their decision heavily influenced by the size of the firm and their available resources.

Out of the six firms Batten had dealings with in the past few months, only one or two decided to go down the route of becoming fully compliant and to undertake all the investment and work that registration entails. The costs of doing this could be as high as GBP 3 million. The other four have decided to “design around the rules”, he observes, adding, “So let’s say a small or mid-sized company has 10 functionalities that allow connectivity to the market. They might decide to keep eight that don’t run into the rules and, for example, outsource the execution piece to a third-party or change their workflow in a way that they can avoid the multilateral test.”

Caveat Emptor in Action – or Not?

The problem from a business point of view is that not being registered as an MTF can be a competitive advantage. Smaller providers trying to eke out a small patch of turf for themselves can only compete with their big, authorised MTF peers if they offer similar services for less money. By seeking authorisation from regulators they don’t just add costs into their business but wipe out their USP at the same time.

On the other hand, companies that have shelled out for registration fees and continue to groan under the ongoing costs of maintaining a regulated trading venue, tend to not get rewarded for their efforts by clients.

There are signs that this is slowly changing, however. While clients have taken a pretty relaxed and cost-driven approach to the issue until now, the largest users are starting to question the wisdom of doing business with a firm that is only on greeting terms with compliance. “It’s not just about service providers. A lot of investment firms are going to their tech vendors to check with them about this. They’re asking “are you sure that you’re not in scope?” Christopher Collins, senior associate at law firm Katten Muchin Rosenman, explains. “Clients want a bit of clarity as well and while existing relationships may continue a bit longer, these questions definitely come up in conversations during the sales process and around onboarding.”

Jurisdictions, Clients and Liquidity

Even firms that are doing their utmost to be compliant with the rules have tricky decisions to make, such as which jurisdiction they should choose as their primary base, bearing in mind that this will be an important factor in where clients can access liquidity from and how they interact with it. “If you’re a new player you have an instant choice to make: do I choose the EU or the UK?” Bovill’s Batten says, noting that the two have become “fairly distinct markets,” evidenced by the fact that most major UK MTFs created EU entities as well.

“Technology companies are facing a stark choice”
Damon Batten, Bovill

He adds that clients tend to lean towards the UK still as a key hub for European hours due to liquidity reasons, meanwhile, those that chose the EU can run into some unexpected niggles. “Not every regulator is interpreting ESMA’s guidance the same way within the EU27, clients tell us that there are different approaches to the guidance,” Batten says.

Katten’s Collins notes that technology providers have to consider not just how clearly the rules are defined in various jurisdictions, but also their implications for liquidity and participation. “Part of the issue is that FX is a cross-border offering,” he says. “Businesses are still digesting whether it’s the UK or the EU that offers them the broadest access, they don’t want to split liquidity.”

The Risk Reward – What’s Really at Stake?

One senior executive at a registered trading platform said that there is a “conspiracy of silence” in the market about non-adherence due to little follow-through from the regulator on the issue. This is especially acute in the UK and Europe, where regulators tend to be less gung-ho with hefty fines and enforcement actions than their peers in the US.

While it’s difficult to find instances where the FCA or ESMA fined a technology company for non-adherence in the venues vs tech firms debate, the CFTC was handing out fines as early as 2021. In October that year the US regulator closed an investigation and settled charges with Symphony Communication Services, for failing to register its RFQ platform SPARC as a SEF. The $100,000 fine wasn’t the point: by taking action the CFTC effectively forced SPARC to shut down.

Those cheering for a robust regulatory response on non-compliance might be hoping for swift and decisive action from the FCA and ESMA. For now, lawyers and the market at large seem to think there is more time before that happens, since undertaking a regulatory risk assessment is in itself a lengthy and onerous process, and authorities appear to take a tolerant view of firms that are attempting to do the right thing.

This is unlikely to last forever, however, and the complexity of a cross-border business will not be enough to stave off regulators in the long-run. “Definitions are still fairly grey but if a company has clients in the US, EU and the UK there is potential for enforcement action from a lot of angles,” Collins points out. “And we should never forget that conducting regulated activities without authorisation is a criminal offence in the UK.”

US Blues

In the US, the CFTC published a new interpretation of its view on what constitutes a SEF in 2021, capturing a much broader segment of providers than previously. It also fined and shut down two companies in the following year. Less than a year after closing Symphony’s SPARC, the CFTC fined and shut down Houston-based commodity trading advisor Asset Risk Management for $200,000 for failing to register as a SEF. After settling with the regulator, ARM sold its affected business unit rather than making the investment required to run a registered trading venue.

A lot of investment firms are going to their tech vendors asking “are you sure that you’re not in scope?”
Christopher Collins
Katten Muchin Rosenman

Despite the swift clampdown and the decisive steps, however, law firm Jones Day noted that as of last April, only 1% of the captured companies had satisfied the new requirements and highlighted the “substantial costs” for commodity trading advisors and introducing brokers, who are captured under the new rules.

“Likely in part due to those costs, only 23 entities to date have registered as SEFs. By comparison, there are more than 2,200 CTAs and IBs. Only a small percentage of those would be able to afford the costs of compliance; the rest would have to shut down or sell,” lawyers at the firm wrote, while underscoring that this interpretation has “downstream effects on the industry at large.”

It would also be somewhat circular, considering that SEFs can arrange to be managed by the National Futures Association, a body which already provides self-regulatory oversight for CTAs and IBs. Jones Day legal eagles think there could be more CTAs and IBs selling up or closing down instead of going down the SEF path.

“This is the inevitable result of the Commission’s attempted expansion of SEF registration requirements. If left unchecked, the Advisory will ultimately reduce competition and deprive consumers of the advisors and brokers they know and trust, with no gains,” they opined.

Let’s Play an Endgame

Regulation is rarely funny or easy to navigate, but in most cases there is little choice for firms to do anything else but take the pain. As service providers and clients both digest and contemplate the implications of these relatively new rules, regulators appear reluctant to act too fast.

One thing is clear, however: their patience won’t last forever. Katten’s Collins expresses hopes that the FCA could take a consultative approach rather than choose enforcement at this point. “The Swiss regulator FINMA, for example, can be very good at being open and discussing risks with market participants, whereas there can be a perception that the FCA would rather regulate than collaborate for issues such as these,” he says. “I think that in this case, because of all the different factors businesses have to consider, the FCA will take a softly, softly approach and allow the market to figure it out. That’s what I’d hope but maybe I’m being optimistic.”

This is little consolation for those businesses who took steps months and years ago and are groaning under the weight of resources and costs they have to sink into running largely unused platforms every day. But in the end, they’ll probably be right.