Classification of an OTF (Organised Trading Facility) 17/12
11th July 2017
MiFID II introduces a new category of trading venue, that of an OTF. An OTF is a multilateral system that is not a Regulated Market (RM) or a Multilateral Trading Facility (MTF).
Definition of an OTF
An OTF is defined under MiFID II Article 4(1)(23) as:
‘organised trading facility’ or ‘OTF’ means a multilateral system which is not a regulated market or an MTF and in which multiple third-party buying and selling interests in bonds, structured finance products, emission allowances or derivatives are able to interact in the system in a way that results in a contract in accordance with Title II of this Directive
Definition of a multilateral system
This is defined under MiFID II Article 4(1)(19) as:
‘multilateral system’ means any system or facility in which multiple third-party buying and selling trading interests in financial instruments are able to interact in the system
Will your firm be an OTF?
ESMA is of the view that an entity should seek authorisation to operate an OTF where the three following conditions are met: a) trading is conducted on a multilateral basis, b) the trading arrangements in place have the characteristics of a system and c) the execution of the orders takes place on a discretionary basis through the systems or under the rules of the system. They expand these requirements as follows:
a) Trading is conducted on a multilateral basis: Interaction with a view to trading in a financial instrument is conducted in such a way that a trading interest in the system can potentially interact with other opposite trading interests. As OTFs are required to “have at least three materially active members or users, each having the opportunity to interact with all the others in respect to price formation” (Article18(7) of MiFID II), an OTF user’s trading interests can potentially interact with those of at least two other users. On OTFs, the interaction of user trading interest can take place in different ways, including through matched-principal trading or market-making, within the limits set out in Article 20(2) and 20(5).
b) The trading arrangements in place have the characteristics of a system: MiFIDII/MiFIR is technology neutral and accommodates a variety of “systems”. A system would be easily identified when embedded in an automated system. This would cover a situation where, for instance, the arrangements in place consist of the automated crossing of client trading interests, subject to the exercise of discretion on an OTF. However, other non-automated systems or repeatable arrangements that achieve a similar outcome as a computerised system, including for instance where a firm would reach out to other clients to find a potential match when receiving an initial buying or selling interest, would also be characterised as a system. Where a firm would, by coincidence and accidentally, receive matching buying and selling interests, and decide to execute those orders internally, such unpredictable circumstances would not qualify as the operation of a system.
c) The execution of the transaction is taking place on the system or under the rules of the system. The execution of the orders would be considered to be taking place under the rules of the system including where, once the trade price, volume and terms have been agreed through a firm, the counterparties’ names are disclosed, the firm steps away from the transaction and the transaction is then legally formalised between the counterparties outside a trading venue.
If an investment firm arranges a transaction between two clients and the clients decide to formalise the trade on a regulated market or an MTF, the transaction would not be considered as taking place under the rules of the system because a transaction cannot be concluded on more than one venue.
ESMA notes that if an investment firm were to arrange transactions on one system and provide for the execution of the transactions on another system for avoidance purposes, the disconnection between arranging and executing would not waive the obligation for the investment firm operating those systems to seek authorisation as an OTF operator.
It is the answer to Question 4 in a recent update to ESMA’s Q & A’s that changed the market’s perspective:
Q:Does the concept of OTF apply to voice trading and, if yes, when an investment firm executing transactions through voice negotiation should be considered as falling under the definition of OTF?
A:Yes. MiFID II is technology neutral and the OTF definition includes voice trading in the same way as the definition of regulated markets and MTFs include voice trading systems. An investment firm executing transactions through voice negotiation would be considered as falling under the definition of an OTF where the arrangements in place would meet the conditions set out [above].
The full updated document is called ESMA Questions and Answers On MiFID II and MiFIR market structures topics.
Rules of an OTF
These will appear in the FCA Handbook under MAR 5A which has yet to be issued. However, the FCA have stated that the requirements for an OTF will be ‘generally the same’ as the requirements for an MTF, which can be found in MAR 5. These are currently defined in MiFID II Article 18.
These are précised by the FCA as follows:
OTFs must establish clear rules and processes around trading. For example, an OTF operator must establish transparent rules and procedures for fair and orderly trading, and publish rules about which instruments can be traded on their venue. They must also establish and publish clear and non-discriminatory access rules, be able to suspend instruments from trading, and maintain resilient systems to facilitate continuity of trading under stressed conditions.
OTFs are also subject to the same transparency requirements as RMs and MTFs. Pre- and post-trade transparency both apply to any order or transaction executed through the systems or under the rules of an OTF. According to the new pre-trade transparency regime, OTF operators will have to publish the details of current bids and offers and the depth of trading interests of those prices. To comply with post-trade transparency rules, OTF operators will have to make public the details of transactions as close to real time as is technically possible.
The FCA have stated that the capital adequacy requirements of an OTF will be the same as that of an MTF. This would mean that the firm would become an IFPRU 730 Limited Licence Firm which has a Pillar 1 capital adequacy requirement of the higher of the following three:
Credit Risk plus Market Risk
Fixed Overhead Requirement
An OTF firm will move into IFPRU reporting requirements if they are not already under IFPRU.
This will mean quarterly CoRep and returns which require specialist software to complete. Other reporting requirements remain the same but are quarterly.
How to become an OTF?
The application is made on FCA Connect and is a variation of permission which will incur an FCA fee of £12,500..
The firm will need a recovery and resolution plan to be submitted at the same time as the application which is quite a complicated piece of work. The applicant firm should also provide a financial forecast for the following year. The ICAAP may well be called for but, as the business of the firm would potentially stay exactly the same, this should just be refreshed should the FCA request sight. The final requirement is to comply with the MiFID II Article 18 requirements which include:
- The establishment of transparent rules and procedures for fair and orderly trading and established objective criteria for the efficient execution of orders.
- Publication, maintain and implement transparent and non-discriminatory rules based on objective criteria, governing access to the facility
- Transparent rules regarding the criteria for determining the financial instruments that can be traded under the system
- Effective systems and arrangements to [run an OTF]
- Arrangements for the settlement of the transactions concluded under the system
Under Article 2(2)(a) – (d) of the commission Implementing Regulation 2016/824 of 25th May 2016, they specifically draw attention to a voice broking system as follows:
A relevant operator shall provide its competent authority with a detailed description of the functioning of its trading system specifying:
(a) whether the system represents a voice, electronic or hybrid functionality;
(b) in the case of an electronic or hybrid trading system, the nature of any algorithm or program used to determine the matching and execution of trading interests;
(c) in the case of a voice trading system, the rules and protocols used to determine the matching and execution of trading interests;
(d) a description explaining how the trading system satisfies each element of the definition of an MTF or an OTF.
The deadlines for investment firms applying for a variation of permission such as this would be 3rdJuly 2017, allowing the FCA the statutory six months to process a complete Variation of Permission application. However, the FCA have stated that the majority of applications they receive are incomplete, so encourage firms to apply as soon as possible to increase the chance of obtaining the relevant permissions by 3 January 2018.
© CPA Audit LLP 2019.