Provisions within Mifid II to regulate direct electronic access could result in thousands of non-EU firms ceasing trading on European derivatives markets.
The European regulator Esma is currently consulting on the technical standards that will form the basis of the implementation of the Markets in Financial Instruments Directive or Mifid II.
Central to the intentions of European regulators is the tightening up of regulation around the provision of direct electronic access (DEA).
Under the current Mifid II text all firms trading on European exchanges through a DEA agreement could be required to be regulated under Mifid II, which among other onerous requirements would necessitate that firm having a physical presence in Europe.
This would mean that thousands of foreign firms, including hundreds of US CTAs and other hedge funds could cease trading on European markets.
“If this is what is ultimately agreed, it could result in thousands of foreign firms simply stopping trading on Eurex and Liffe and other European markets overnight,” said one broker speaking under condition of anonymity.
Exemption from the exemption
At the centre of the current fears over the reach of Mifid II is the so called “exemption from the exemption” in Article 2(d) of the Mifid II text.
This article states that all firms who have direct electronic access to a trading venue are exempt from the broader exemption that covers firms that trade on their own account.
The full implications of the exemption from the exemption are only now becoming apparent following the release of the Consultation Paper from Esma and subsequent discussions between market participants and local regulators.
Should the proposals be implemented as written in the text, non-EU entities trading electronically will need to become regulated in the EU under Mifid to continue to trade on European exchanges via a DEA arrangement with an FCM.
It also calls into question whether the current FCM omnibus relationship model in which a US entity offers local clients access to EU markets via an omnibus structure with the FCM’s EU entity.
Potentially all US clients would have to sign up with the FCM’s European entity for DMA access and be regulated as an EU entity.
Non-EU firms are supposedly not in scope of Mifid II, however, it is believed that the DEA provisions could over-ride this exemption as has been the case with the German HFT law.
Get out clause?
In the Consultation Paper, Esma states that it “considers…clients transmitting orders to an investment firm in an electronic format to be outside of the scope of DEA, as long as the electronic access to the market is shared with other clients through a common connectivity channel, no specific capacity and latency is provided to any particular client (e.g. web based applications)”.
This is understood that this exemption applies to retail focused web-based firms rather than FCMs tailoring to the professional market but will be used by market participants to push for a wider provision of this de-scoping.
The market has long feared a fragmentation of liquidity in the face of extraterritorial implementation of local laws. Efforts between US and European regulators to establish equivalence that would mitigate extraterritoriality have been beset by problems.
News of the potential requirement for non-EU firms to become authorised under Mifid II comes as DEA providers are coming to terms with the implications of the additional controls and due diligence they must have for their clients.
FCMs have warned that DEA providers could be unwilling to underwrite the risks of reviewing and taking responsibility for third party algorithms resulting in less choice and higher fees for market users who will be forced to rely on manually executed electronic care orders and voice orders.