UK WHOLESALE MARKETS REVIEW

The U.K. government is consulting, in the Wholesale Markets Review,^[1] on proposals to amend the U.K.’s Markets in Financial Instruments regime. This regime is based upon the Markets in Financial Instruments Directive and related Regulation, as well as several pieces of delegated legislation thereunder, collectively and colloquially known as MiFID II, which the U.K. on-shored with minor amendments following its exit from the European Union. HM Treasury is now seeking feedback on how the U.K.’s approach to regulating secondary markets should be adapted now that the U.K. has left the EU. The intention is to amend the regime to reflect that the U.K. market is one of the largest capital markets globally. Changes are also proposed where the rules have had unintended outcomes, are duplicative or excessive or have curbed innovation. Responses to the consultation may be submitted until September 24, 2021.

The proposals are wide-ranging and will impact many market participants. Some of the changes represent fundamental amendments to the regime, for example, those for the commodity derivatives markets, while others focus on reducing unnecessary burdens on market participants. All the changes demonstrate the U.K. government’s commitment to high standards and proportionate regulation.

The final changes to the U.K.’s MiFID II regime will be implemented either through legislation or changes to the regulator’s rulebooks. The Financial Conduct Authority is expected to consult on related rule changes before the end of the year. Feedback to this consultation will be considered alongside the Future Regulatory Framework Review, in which HM Treasury is seeking to establish a blueprint for U.K. financial services regulation, ensuring a clear division of responsibilities between government, Parliament and the regulators, providing for appropriate policy input by democratic institutions and allowing regulation to adapt to changing conditions.

This client note summarizes the key proposals discussed in the Wholesale Markets Review consultation.

Examples of Proposed Fundamental Changes

Commodities Derivatives Markets and Position Limits

MiFID II requires the FCA to establish and apply position limits on the size of a net position in commodity derivatives traded on trading venues and economically equivalent OTC contracts. The limits apply to the size of a position that a person can hold, including any other positions held on behalf of that person by group entities. Trading venues are required to apply position management controls, including monitoring of open interest and obtaining information about the size and purpose of a position entered into, beneficial or underlying owners, concert arrangements and any related assets or liabilities. Trading venues also have powers to require termination or reduction of positions and to require a person to provide liquidity back into the market at an agreed price and volume to mitigate the effect of a large or dominant position. The position reporting regime is intended to support the application and enforcement of position limits.

The government believes there is potential for the U.K. to go further than the recent EU MiFID II Quick Fix changes^[2] and to substantially reduce the scope of the U.K. MiFID II requirements. The proposals include:

• Reduce scope by removing: (i) derivatives that are not based on physical commodities; (ii) other types of financial instruments which refer to commodities as a pricing element but are securities in their legal form; and (iii) OTC contracts that are economically equivalent to exchange traded commodity derivatives. The scope would therefore be limited to agricultural contracts and physically settled contracts. The main objective is to remove the legal risk and compliance costs arising from uncertainty about which contracts are in scope.

The EU’s MiFID II Quick Fix will, once it applies, reduce the scope of the EU position limits regime to agricultural commodity derivatives and to critical or significant commodity derivatives traded on trading venues and their economically equivalent OTC contracts. Critical or significant derivatives are commodity derivatives with an open interest of at least 300,000 lots on average over a one-year period.

• Revoke the requirement for position limits to be applied to all exchange traded contracts and transfer the setting of position controls from the FCA to trading venues (as was done pre-MiFID II). The FCA would set a framework for trading venues to manage positions and would be able to intervene in the event of market volatility. This means the daily commodity derivative position reports to trading venues and the FCA will be kept enabling FCA monitoring. However, HM Treasury indicates that it is open to any recommendations for improving the reporting regime.

• Extending the position limit exemption, which currently applies for non-financial counterparties hedging risk, to all liquidity providers. Regulated firms would be allowed to facilitate hedging activity for a commercial entity, even where the hedged risk arises off-exchange or on a different trading venue. This in line with the FCA’s December 2020 announcement^[3] that from January 1, 2021 it would not take supervisory or enforcement action for breaches of position limits where the breach arises from a position held by a liquidity provider to fulfil its obligations to provide liquidity on a trading venue. The FCA has since confirmed that position^[4] and has stated that it will not act for commodity derivative positions that exceed position limits on cash-settled commodity derivative contracts, unless the underlying is an agricultural commodity.

The EU MiFID II Quick Fix will introduce a narrowly defined hedging exemption for an authorized financial institution within a predominantly commercial group that trades on behalf of that commercial group. There is also an exemption for positions resulting from transactions undertaken to fulfil obligations to provide liquidity.

• Revert to the pre-MiFID II qualitative ancillary activities test, which was more streamlined, proportionate and cost effective. There would be a principles-based approach, which considers the nature of a firm’s business more holistically according to criteria set by the FCA. According to HM Treasury, the current quantitative-based test requires firms to perform complex calculations and process substantial volumes of historical trading data. In addition, since it was introduced in 2018, no firms have exceeded the threshold. The new test would not be backward-looking, but a more proactive assessment of a firm’s expected activities. Furthermore, it is proposed to remove the requirement annually confirm to the FCA that the threshold has not been reached.

The EU MiFID II Quick Fix also amended the ancillary activities test; however, it is a more limited change than that posed by HM Treasury. EU national regulators will be able to combine a quantitative and qualitative assessment, based on guidance to be issued by the European Commission.

• Delete the oil market participants (OMP) and energy market participants (EMP) regimes as set out in the FCA Handbook. These are old regimes that were originally intended to be temporary. Firms subject to these regimes would become subject to the MiFID II requirements for commodity derivatives unless they fell out of scope under the new ancillary activities test.

Trading Venue for Smaller SMEs

The government is proposing to introduce a new type of trading venue or additional segment on existing platform tailored to requirements of smaller SMEs, giving as an example, SMEs with a market capitalization under £50 million.

The SME MTFs are working well, but evidence shows that they are mostly being used by medium-sized issuers and smaller issuers use crowdfunding and private markets to access funding, mostly because of overly burdensome requirements. Establishing the new trading venue could, among other things, involve:

• amendments to the U.K.’s Market Abuse Regulation to alleviate costs arising from continued compliance associated with being publicly traded;

• a new offer document regime that would be set by market operators, not the regulators; and

• new eligibility criteria, including reduced disclosure requirements.

Consolidated Tape

MiFID II introduced requirements for a consolidated tape for equity and non-equity instruments including requiring a CTP to collect post-trade information published by trading venues and approved publication arrangements and to consolidate this into a continuous live data stream made available to the public, both for equity instruments and non-equity products. No CT has yet been set up in either the U.K. or the EU.^[5]

HM Treasury is seeking feedback on the establishment of a fixed income consolidated tape. The government is making this proposal to increase data standardization and accessibility and indicates that its preferred model is a private sector CT to ensure competition. To promote a private sector CT being set up, the government is proposing to:

• mandate the submission of data to a CT by trading venues and Approved Publication Arrangements;

• require any private sector CT to have an appropriate governance structure and to operate in a transparent and accountable way;^[6]

• remove (or reduce the limits of) the requirement for CTs to provide 100 percent coverage of equity trading activity or 80 percent coverage of fixed income trading activity;

• remove the requirement for CT providers to provide their data streams for free after 15 minutes; and

• standardize fixed income deferrals to allow effective consolidation.

The consultation paper states that industry engagement shows support for an equity CT for both pre-trade and post-trade data, and a fixed income CT for post-trade data. HM Treasury’s view is that a fixed income CT is more urgent because the market is less concentrated and is mostly executed OTC. The U.S. has a version of a fixed income CT in the form of the Trade Reporting and Compliance Engine, which the Financial Industry Regulatory Authority developed to facilitate the mandatory reporting of OTC transactions in fixed income securities.

Examples of Proposals for Changes That Would Better Suit the UK Market or Reduce Burdens

Lifting Restrictions Applicable to MTFs and OTFs

HM Treasury is proposing to remove some of the limitations that are imposed on multilateral trading facilities and organised trading facilities, including allowing:

• Matched principal trading by an MTF, conducted under clear, transparent and nondiscretionary rules. HM Treasury asks for feedback on the potential effect of this proposal on market integrity.

• An investment firm to operate a Systematic Internaliser and an OTF within the same legal entity where the two activities are clearly segregated. The main issue here is whether the conflicts of interest are manageable.

• OTFs to execute transactions in packages involving derivatives and equities.

Adjusting the Systematic Internaliser Threshold

It is proposed that the U.K. reverts to a qualitative threshold to determine whether an investment firm must be authorized as a Systematic Internaliser. The existing quantitative threshold requires firms to undertake calculations that are calibrated at different levels for each asset class. To avoid the cost and administrative burden of the calculations, a lot of firms have opted into the Systematic Internaliser regime for all assets that they trade in. The government suggests moving to a qualitative definition where the Systematic Internaliser determination goes according to a firm’s market activity for a particular asset class. The determination would be made at entity level, not by asset class. It is hoped that these proposals would alleviate some of the reporting responsibility uncertainties.

Amending the Tick Size Regime

The MiFID II “tick size” regime establishes minimum increments by which prices for equity and equity-like instruments can change. The requirements are intended to mitigate against high frequency trading gaining execution priority by offering fractional price changes as this could lead to disorderly markets and negatively impact price formation.

The calculation of tick sizes is based on the liquidity of the most liquid market in the U.K./EU, without any consideration being given to the liquidity on non-U.K. and EU trading venues. This has resulted in unnecessarily larger tick sizes for overseas shares. HM Treasury is proposing to change the tick size regime so that trading venues can follow the tick sizes applicable in the relevant primary market of a share where that share does not have its primary market in the U.K.

The government is also seeking feedback on whether the setting of tick sizes for shares admitted to trading for the first time should be delegated to trading venues, with appropriate controls. The government’s view is that trading venues have more insight into market demand at this stage than the FCA and may be better placed to undertake this role.

Tweaking the Derivatives Trading Obligation

MiFID II imposes a trading obligation on financial counterparties and non-financial counterparties for transactions in derivatives that: (i) have been declared subject to the clearing obligation under the U.K.’s European Market Infrastructure Regulation; (ii) are admitted to trading or traded on at least one U.K. trading venue (a regulated market, MTF or OTF) or a third-country equivalent trading venue; and (iii) are sufficiently liquid.

It is proposed that the scope of the derivatives trading obligation should be aligned with that of the clearing obligation under U.K. EMIR. This would remove ambiguity where small financial counterparties are out of scope of the clearing obligation, but still subject to the DTO.

The government is also considering extending, subject to certain conditions, the exemption from the DTO for the termination or replacement of component derivatives in portfolio compression to all non-price forming post-trade risk reduction services. Views are sought on whether the same exemptions should apply to the clearing obligation under U.K. EMIR.

HM Treasury is also contemplating granting the FCA a permanent power to modify or suspend the application of the DTO, after it has consulted with the government. This is based on how market disruption was avoided by the FCA using its temporary transitional power to amend the scope of the U.K. DTO for Brexit.

Revising the Transparency Regime

MiFID II imposes pre- and post-trade transparency requirements for equity and non-equity financial instruments that aim to improve the quality and availability of market data and reduce the costs of purchasing data. The pre-trade transparency obligations require market operators and investment firms operating a trading venue to make public current bid and offer prices and the depth of trading interests at those prices which are advertised through their systems for equity and non-equity financial instruments.

Some of the proposals for enhancing the transparency regime include:

• Clarifying the scope of the transparency regime, particularly for OTC derivatives, as it currently depends on whether a financial instrument is “traded on a trading venue.” This concept is not defined. It is therefore proposed that the ToTV terminology is removed. The scope would center instead on whether a financial instrument is centrally cleared, either voluntarily or according to rules.

• Reducing the number of deferrals available for fixed income and derivatives post-trade publication. Currently, the publication of trades that can be deferred for up to four weeks are: (a) block trades; (b) trades deemed illiquid according to liquidity calculations; (c) trades above a size specific to the instrument (SSTI), or; (d) package orders. HM Treasury is proposing that only the deferrals for (a) and (b) would remain. However, the timing of the deferrals will be subject to consultation by the FCA, potentially making it shorter for block trades and longer for SSTIs.

• Revising the scope of the pre-trade transparency regime for fixed income and derivatives. In scope would be systems such as electronic order books and periodic auctions, that currently operate under full transparency. Bilateral trades would be out of scope.

Examples Of Requirements That Could Be Removed

Share Trading Obligation

U.K. MiFIR requires U.K. investment firms to ensure that the trades they undertake in shares admitted to trading on a regulated market or traded on a trading venue take place on a U.K. regulated market, MTF, Systematic Internaliser or equivalent third-country trading venue. It is proposed that the share trading obligation be removed. It was introduced to bring more trading onto lit markets and increase transparency; however, these objectives have not been achieved. The STO is solely an EU concept and is not based on international standards. Furthermore, other jurisdictions do not have a STO, including the U.S., Switzerland, Australia and Hong Kong, all of whom benefit from U.K. STO equivalence.

Market Making Agreements

The government is proposing to remove the requirement for algorithmic trading firms with a market making strategy to enter into binding, written market making agreements with trading venues, including the need for both entities to have effective systems and controls in place to fulfil their obligations under the agreement.

Examples Where Clarification May Be Beneficial

HM Treasury also points to areas where clarification would be beneficial, indicating that its preferred option would be to bring that about through regulatory guidance. One example is the regulatory perimeter for trading venues. HM Treasury recognizes that under the current definitions there is uncertainty as to whether a technology firm that allows investment firms to exchange trading interest and execute transactions with their clients needs to be authorized as an MTF. In addition, there is uncertainty about the regulatory status of brokers arranging transactions over the phone without operating a central mechanism to match client orders.

Another example highlighted in the consultation paper focuses on the roles of market operators and participants during an outage. HM Treasury’s view is that more is needed to ensure that trading can continue during market outages and that this could be done through the FCA developing common procedures, communication standards and guidelines.