Policy responses
The increase in market fragmentation and dark trading has been associated with a
growing debate about the consequences for essential market qualities, such as the efficiency
of price formation, fairness between investors, level playing field between venues and
conflicts of interest between service providers and clients. In several countries, this has
already led to regulatory responses. Australia and Canada for instance, have both introduced
so-called “trade-at” rules which allow a trade to be executed on an off-exchange trading
venue only if it provides a price or size improvement over exchanges (Shorter and Miller,
2014).
In other jurisdictions, recently launched initiatives may lead to substantial changes.
The two most important regulatory initiatives currently undertaken by advanced economies
includes the US SEC’s recent proposal to change the regulatory framework for ATSs in the
United States and the announcement by the European Commission that MiFID 2 will enter
into application in January 2018.
The proposed reforms in the United States
In November 2015, the US SEC submitted an extensive proposal to amend the regulatory
framework for ATSs that trade NMS stocks in the United States. The main focus is on
differences in operational transparency between ATSs and national securities exchanges and
the lack of transparency around potential conflicts of interest between the broker-dealer
operator of the ATS and the ATS’s subscribers. An important reason for these differences is
that national securities exchanges and ATSs today operate under different regulations.
National securities exchanges must, for example, be registered with the US SEC. They must
fully disclose their operations and procedures, establish publicly disclosed rules for trading,
and submit any changes in their rules to US SEC’s for approval. In contrast, ATSs must
register as broker-dealers, which includes becoming a member of a Self-Regulatory
Organisation (SRO), and comply with Regulation ATS, which includes noticing its operations
to the US SEC on Form ATS. Form ATS is not approved by the US SEC and it is deemed
confidential upon filing. ATSs are not required to publicly disclose the character of their
trading services, operations, and fees and are not required to file proposed rule changes that
national securities exchanges are required to file.
The US SEC’s reform proposal from November 2015 would require that ATSs that trade
NMS stocks and that want to be exempted from registering as a national securities exchange,
comply with additional conditions and increase the transparency of their operations.
The
proposal would increase the filing requirements regarding the activities of the ATS operator
(broker-dealer) and its affiliates in connection with the ATS that trades NMS stocks. The ATS
broker-dealer operator would be required to disclose certain information through Form ATS-N
and the US SEC would make it available to the public. The US SEC would also determine
whether ATSs that trade NMS stocks would qualify for the exemption from registration as an
exchange and would review the Form ATS-N for compliance with the form’s requirements. The
proposal would also allow the US SEC to suspend, limit or revoke the exemption provided.
Under the proposed regulation, ATSs would also be required to have the ATS’s safeguards and
procedures in writing to protect their subscribers’ confidential trading operations.
Overall, the US SEC proposal aims to level the regulatory environment between ATSs
that trade NMS stocks and national securities exchanges by means of increasing the
requirements for ATSs that trade NMS stocks and increasing the information available to
market participants.
4. CHANGING BUSINESS MODELS OF STOCK EXCHANGES AND STOCK MARKET FRAGMENTATION
138 OECD BUSINESS AND FINANCE OUTLOOK 2016 © OECD 2016
The European Union and MiFID 2
MiFID 1 was adopted in 2007 and covers a broad range of market rules related to
market structure, transparency, supervision and investor protection. It also includes rules
related to trading and clearing of financial instruments, such as shares, bonds and
derivatives and the venues on which they are listed or admitted to trading. MiFID 2, which
replaces MiFID 1,
was approved by the European Council in May 2014. The European
Commission has extended the original application date for MiFID 2 which was January
2017 to January 2018 in order “to take account of the exceptional technical implementation
challenges faced by regulators and market participants” (European Commission, 2016).
An important rationale for MiFID 1 was to promote competition between different
trading venues and decrease the costs for investors. MiFID 1 explicitly allows equity trading
to be executed on stock exchanges, MTFs and internal trading systems of firms (systematic
internalisers). However, and outside the scope of MiFID 1, it is also possible to execute
trading on an OTC basis outside of all these three venue types. Broker crossing networks, for
example, without being classified as any of these three categories and without being subject
to related regulatory requirements, are frequently used to execute trades in listed equities.
MiFID 2 aims to ensure that all multilateral trading is executed either on exchanges or MTFs;
and that bilateral transactions are carried out on the internal trading systems of firms. Under
certain conditions, it will still be possible to carry out trading on a traditional OTC basis.
MiFID 1 also allows trading to be executed without orders being subject to pre-trade
transparency. There are four types of waivers from pre-trade transparency of orders:
1) large in scale transactions, 2) transactions based on a reference price generated by
another system, 3) negotiated transactions; and 4) orders held in an order management
facility of the trading venue. MiFID 2 will maintain these waivers but introduce certain
restrictions. Of particular interest regarding fragmentation between lit and dark trading is
the so-called “double volume cap mechanism”. This mechanism stipulates that the dark
volume of trading on any trading venue for a particular share should not exceed 4% of the
total trading volume on all trading venues in the European Union, and 8% across all trading
venues based on a 12-month rolling calculation. The caps will only be applied to dark
trading that is making use of the reference price waiver and some types of negotiated
transactions. Importantly, the caps will not target dark trades under the waivers for large
in scale transactions and trades executed on an OTC basis. This means that the total
volume of dark trading under MiFID 2 may amount to 8% of the total trading volume that
uses the reference price waiver and some types of negotiated transactions plus all trading
that makes use of the large in scale and order management facility waivers plus all trading
that is executed outside of the three venues defined by MiFID 2.
A main difference between the United Stated and European equity markets is access to
reliable and consistent aggregate trading data. In the United States, the Consolidated Tape
Association, which is a membership organisation of exchanges, oversees the dissemination
of real-time trade and quote information in listed securities. For the time being, there is no
similar pan-European facility. While recognising the need to improve the situation in Europe,
MiFID 2 takes a somewhat different approach to the organisation of consolidated data
dissemination. The Directive envisages that a consolidated tape will be established by data
providers that collect trade reports from the exchanges, MTFs and other reporting
mechanism used by investment firms and consolidate this information into a continuous
electronic live data stream providing price and volume data for each financial instrument.
