Online investment platforms and secondary markets: are you prepared for MiFID II?

Reasons for the changes to the regime

MiFID II's new multilateral system regime is designed to harmonise the regulation of trading platforms. The aim is to ensure that platforms previously subject to less rigorous regulation under MiFID I are brought in line with other platforms to create a more level regulatory playing field.

MiFID II ensures that all platforms trading in financial instruments are appropriately regulated. MiFID I failed to anticipate the development in technology that has facilitated the introduction of trading venues not envisaged by the original legislation. The aim of amending MiFID I in this area is to bring in additional requirements including, amongst other things, increased trade transparency. Below the differences in trading venue are outlined in more detail along with the ramifications this will have for both existing and new platforms.

Key differences in trading venues

Conduct of Business requirements

There are a number of conduct of business rules that will continue to apply to all trading venues (for example rules relating to conflicts of interest and inducements). Consideration is given below to the key conduct of business rules under MiFID II. With respect to MTFs these will not apply to transactions between its members or participants or to transactions between members and the MTF itself. They will apply to members in an MTF when they execute orders through an MTF on behalf of their own clients. Contrastingly these rules will also apply to platforms carrying on the new regulated activity of operating an OTF.

a) Giving information to clients – acting honestly, fairly and professionally. This includes ensuring that marketing materials are fair, clear and not misleading and that advice is tailored to the relevant client.

b) Suitability – demonstrating that individuals acting on your behalf have the necessary knowledge and competencies and whether the investment service offered is appropriate for the client.

c) Best execution – taking steps to ensure the best possible result for the client with regard to cost, account price, costs, speed, likelihood of execution and settlement, size and nature.

d) Client order handling – implementing steps and procedures to provide the prompt, fair and expeditious execution of client orders, relative to other client orders or the trading interests of the firm.

You must therefore ensure that either (a) you are confident these rules do not apply to your platform or (b) you have effective systems and controls in place to comply with the rules. Please feel free to contact us if you are unsure.

Capital requirements

Both MTFs and OTFs will now be required to have a minimum capital requirement of €730,000 in line with the Capital Requirements Directive. This is subject to upward revision. For existing MTF platforms and platforms seeking to carry out the regulated activity of operating an MTF this is a dramatic increase that may have a large impact, particularly on smaller platforms unable to meet this requirement.

In addition, platforms solely carrying on the regulated activity of arranging deals in investments, but falling outside the definition of a multilateral system, are subject to much less stringent capital requirements. Depending on the nature of the platform the capital requirement may only be €50,000. It is therefore important for platforms seeking authorisation to consider the structure of their model and the financial ramifications this may have. In addition, pre-existing platforms must be aware of the adaptations they will be required to make and the time frame in which this will need to be made which we have outlined at the end of this document.

Financial Instruments

If your platform operates an MTF, it may execute trades in all types of financial instruments including equity instruments such as shares, exchange traded venues and depository receipts or non-equity instruments such as bonds, structured finance products, emission allowances (a new financial instrument under MiFID II) and derivatives.

Contrastingly any platform now classed as an OTF may only deal in non-equity securities thereby limiting the scope of an OTF to platforms that execute trades in non-equity instruments on a discretionary basis.

Discretion

Perhaps the most crucial difference between investment firms operating an MTF or an OTF is the rules under which each can execute transactions. Transactions on an MTF platform must be conducted on a non-discretionary basis. However, those executed on an OTF are subject to limited operator discretion.

Under MiFID I platforms executing transactions under discretionary rules were not as heavily regulated as those executing transactions on a non-discretionary basis. Those platforms are now likely to fall within the definition of a "multilateral system". Therefore, such online investment platform and/or a secondary market as will need restructure to be either an MTF, OTF or regulated market. As discussed above, the time frame for doing this is becoming increasingly urgent and legal advice should be sought where there is uncertainty.

Notwithstanding the above, it should be noted that platforms and platforms on which there is no genuine interaction between trading interests, for example bulletin boards used for advertising buying and selling interests, would not be caught by the "multilateral system" definition and would likely fall outside the definition of multilateral system under MiFID II.

Pre and post trade transparency

Outlined below are new requirements for pre and post-trade transparency. Whether you operate a new or existing platform you should carefully analyse these requirements and consider (a) if you have effective systems and controls established to ensure compliance and (b) whether you may be eligible for any pre-trade waiver or post-trade deferral. The pre and post-trade requirements for equity and non-equity instruments are largely the same but those relating to waivers and deferrals are subtly different.

Pre-trade transparency (equity and non-equity instruments)

Irrespective of the type of instrument being traded, any platform categorised as an MTF or an OTF must:

a) publicise the current bid and offer prices; and

b) the depth of the trading interests at those prices;

as advertised through the system for equity/non-equity instruments traded on the platform.

The information must be publicised on a continuous basis throughout normal trading hours. Platforms must also provide access to the mechanisms used to make such information public.

MTF and OTF - Post-trade transparency (equity and non-equity instruments)

Firms must publicise the price, volume and time of the transactions executed in respect of equity/non-equity instruments that are trading on that platform. Such information must be made as close to real time as is technically possible and platforms must give similar access to the implementing mechanisms.

MTF – Pre-trade waiver and post-trade deferral (equity instruments only)

The system for equity waivers will not change dramatically from MiFID I such that you can apply for an equity pre-trade waiver in the case of:

a) systems which match orders according to a reference price;

b) systems that formalise negotiated transactions which are:

• made within the current volume weighted spread reflected on the order book or the quotes of the market makers of the platform operating that system, subject to the conditions in article 5 MiFIR (volume cap mechanism);
• in an illiquid share, depository receipt, exchange-traded funds, certificate or other similar financial instrument not falling within the meaning of a liquid market, and are dealt within a percentage of a suitable reference price, being a percentage and a reference price set in advance by the system operator; or
• subject to conditions other than the current market price of that financial instrument.

c) large scale orders; or

d) orders held in an order management facility pending disclosure.

Deferrals to post-trade transparency requirements are granted, subject to different parameters, if:

a) the transaction exceeds a certain size (whether the transaction does exceed a particular index will also be dependent on the average daily turnover of the platform in the EU).

b) the transaction is between an investment firm dealing on "own account" with a counterparty (excluding matched principal transactions);

c) the length of the deferral is established based on the size of the transaction and asset class; and

d) the deferral is until no later than the end of the trading day (if the trade occurs late in the day this is extended until 12 noon on the next working day).

OTF – Pre-trade waiver and post-trade deferral (non-equity only)

An operator or investment firm may apply for a non-equity pre-trade waiver in the case of:

a) orders that are large in scale;

b) orders held in an order management facility pending disclosure;

c) actionable indications of interest in request-for-quote and voice trading systems; or

d) derivatives that are not subject to the trading obligation in article 28 MiFIR (obligation to trade on regulated markets, MTFs or OTFs in respect of derivatives) and other financial instruments for which there is no liquid market.

Deferrals to post-trade transparency requirements granted if the transaction:

a) is large in scale (in comparison to normal market size);

b) involves instruments for which there is no liquid market;

c) is above the size specific to the instrument where the investment firm is dealing on its own account (other than on a matched principal basis); and

d) is a package transaction meeting certain requirements.

Execution against proprietary capital/matched principal trading and market making

Execution against proprietary capital, matched principal trading and market making are all prohibited for platforms operating an MTF. However, it should be noted that under the FCA's Policy Statement dated 31 March 2017, an investment firm with the appropriate permission, may execute orders against proprietary capital or engage in matched principal trading outside of the MTF that it operates. In other words the prohibition applies to the operation of the MTF only and not to the investment firm's business as a whole.

Platforms operating an OTF may engage in matched principal trading (with client consent) except in derivatives and strictly independent market making. However, platforms operating an OTF may not execute against its own proprietary capital or against the proprietary capital of any member of the firm's group. This group restriction on execution against proprietary capital is wider than the exclusion for firm's operating MTFs and may therefore negatively impact those platforms that are caught by it.

Action points

Firms that operate an online investment platform and/or a secondary market will need to consider whether they fall within the definition of a "multilateral system".

If such firms do operate a "multilateral system", they will need to consider how to restructure their platform to fall within the definition of either an MTF, OTF or regulated market. This is likely to mean not only an upheaval of the business model, but far more stringent regulation and more onerous requirements.

Such firms are also going to need to apply to the FCA to either become authorised to operate such a platform (as an MTF, OTF or regulated market). Where firms are already authorised by the FCA for other activities, this will involve applying to the FCA to vary the scope of their permission to include the relevant additional regulated activities.

It should be noted that where investment firms operate, or plan to operate an OTF, there is a requirement to explain during the application or VOP process why the firm cannot operate as a regulated market, an MTF or a systematic internaliser. Firms must be able to continue to demonstrate this throughout the period in which the firm operates an OTF.

Key dates

[1] We will provide further guidance should the FCA issue updated perimeter guidance.