MiFID II UK Shake Up - More Marathon Than Sprint

On 1 March 2022, HM Treasury published its response to its July 2021 consultation on the Wholesale Markets Review, confirming the removal of the share trading obligation, changes to the systematic internaliser regime and coming guidance via the FCA on defining multilateral systems. The publication is the latest step in the emergence of a post-Brexit UK MIFID regime. Although, the changes are often material (in particular share trading obligation and proposed changes to the SI regime), it appears to represent a compromise between two different strands of market feedback. On the one hand, the idea that financial firms have spent time and resources ensuring that they comply / have the infrastructure for certain MiFID II obligations and do not necessarily want to spend time/resource unpicking all of these. It appears this has been weighed against the opportunity to remove unnecessary or disproportionate regulation. John Glen's speech in relation to the response seems to chart a course through these twin considerations.

On timing, much of the below will take place when parliamentary time allows - this will require a new Bill to be presented to carry out primary legislative changes (announced probably as part of the next Queen's speech, in May). On 3 March 2022, the FCA published a speech by Edwin Schooling Latter, Director of Markets and Wholesale Policy, on setting out how the FCA would be taking forward certain aspects of the Wholesale Markets Review.

At the EU level, the European Commission published its proposals to amend aspects of MiFIR in November 2021 covering similar areas (see our briefing), although UK proposals differ in a number of ways. We take a closer look below at main points.

Systematic Internalisers (SIs)

• Definition of a systematic internaliser: The Government is proceeding with its proposal to replace the current definition of systematic internalisers (SIs), which requires firms to carry out quantitative calculations on a regular basis, with a qualitative one. This is one of the bigger changes and appears to be a difference between the UK and the EU on how the SI regime is constructed. The net effect is likely to be a reduction in SIs in the market - although this depends on the conclusions of the FCA in relation to post-trade reporting amendments. If the post trade reporting requirement is decoupled from the SI requirement, there is likely to be a significant reduction in SIs. It was always a bizarre outcome that the post trade reporting obligation drove SI "opt-ins".
• SI reporting: The Government proposed determining SIs at an entity level rather than on an "instrument-by-instrument" basis for the purpose of reporting and confirms that the FCA will likely be looking at this issue in the first half 2022 and will take the response into account. In his speech, Mr Schooling Latter confirms that the FCA will seek views on allowing firms to elect to be trade reporters regardless of whether they are a systematic internaliser in a particular instrument. He also confirms that the FCA is open to considering the idea of maintaining a list, or golden source, of these reporters.
• SIs and mid-point: The Government has noted that it considers that the specific restrictions to midpoint execution might not be required, so long as SIs consider the extent to which their use of midpoint execution is consistent with their best execution obligations. The use of the word "might" creates some uncertainty here; it is unclear whether the Government has fully made up its mind on the specifics. Under EU proposals, the European Commission is proposing that SIs should no longer be allowed to match at midpoint below twice the standard market size.
• Increasing the minimum quote size as a proportion of "standard market size" (SMS): The Government notes support for increasing the minimum quote size for equity SIs as a proportion of SMS and believes that the best way of implementing this change is via the FCA.

Equity Markets

• Share trading obligation: The response confirms that legislation to remove the share trading obligation (STO) will be introduced when parliamentary time allows (probably later in the year). In its legislative proposal to amend MIFIR, the EU in contrast proposed clarifying the parameters of the EU STO and requiring ESMA to publish and maintain a list of all shares subject to the STO. The Government states that removal of the UK STO will not include deleting article 23(2) of MiFIR, as the Government considers that this assists in marking out the distinction between bilateral and multilateral trading and prevents the operation of a crossing network by an investment firm that does not have a trading venue permission. Reasonable people might disagree with this and suggest that it is duplication of the general requirement that "multilateral" systems be trading venues (on which more below).
• Removal Double Volume Cap: The Government confirms that legislation will be introduced to remove the DVC when parliamentary time allows (the FCA suspended the DVC for UK and EU securities in early 2021 and Mr Schooling has stated that suspension has made little difference). In contrast, the EU has set out proposals to replace the DVC with a single volume cap set at 7 per cent of trades that are executed under the reference price waiver or the negotiated trade waiver. The response states that the FCA will continue to monitor the level of dark trading and will retain its current ability to limit it where there is evidence that the volume of such trading is undermining the efficiency of the price formation process.
• Reference price waiver (RPW) amendments: The Government confirms that it is proceeding with its proposals to allow reference price systems to match orders at the midpoint within the current bid and offer of any UK or non-UK trading venue that offers the best bid or offer (so long as it supports best execution). It states that this area is a priority area and legislative changes will be introduced to delegate the pre-trade equities waivers regime to the FCA when parliamentary time allows. The Government also confirms that the FCA will consult in the first half of 2022 on extending the concept of the most relevant market in terms of liquidity for the purposes of the RPW to include overseas trading venues. The Government argues that this will broaden the approach that is currently being taken in relation to EU and Swiss shares. This would allow prices derived not only from EU venues, but also those in other jurisdictions such as the United States or Switzerland. Mr Schooling also referred to this in his speech and confirmed that the FCA would be consulting on allowing UK trading venues to source reference prices from any overseas trading venue, providing those prices are robust, transparent, and consistent with best execution.
• Market making strategy for algorithmic trading: The Government confirms that the requirement for algorithmic trading firms to enter into market making agreements with trading venues when they pursue market making strategies will be removed and that this will be taken forward by the FCA.

Trading Venues

• Trading venue definition: Despite concerns in relation to the regulatory perimeter, the Government states that it will not be amending the legal definition of a multilateral system and the FCA to work with HMT and will consult on new guidance in the first instance. At the EU level, ESMA has published an Opinion on the trading venue perimeter in response to market uncertainty concerning the perimeter between bilateral and multilateral systems and also set out its views in relation to the regulatory treatment of order management systems (which are referred to in the UK response).
• Matched principal trading for an investment firm operating an MTF: The Government states that there is a clear case for removing matched principal trading restrictions for investment firms operating a trading venue. This will be welcomed by those who are establishing themselves and wish to be able to trade as principal on an MTF, if only for settlement purposes. There was never a clear rationale for prohibiting all principal trading by an operator; the prohibition was a bit sledgehammer to a nut.
• Restrictions on investment firms operating an SI and OTF within the same legal entity: The Government has confirmed that it remains undecided and will look into this issue further, given concerns raised about potential conflicts of interest that arise.

Fixed Income and Derivatives Markets

• Realigning the scope of the derivatives trading obligation: The Government is proceeding with its proposal to bring counterparties in scope of the derivatives trading obligation (DTO) in line with those subject to the clearing obligation (CO). The November 2021 EU proposals to amend MIFID also contained plans to align the derivatives trading obligation under MiFIR with the clearing obligation for derivatives under the EMIR Refit Regulation.
• DTO exemptions: The Government is proceeding with its proposal to expand the grounds for an exemption from the DTO beyond portfolio compression to all post-trade risk reduction (PTRR) services. Again this is much needed, and will end some of the head-scratching in this area.
• Pre and post trade transparency regime: The Government had made a number of very significant proposals in this area. Chief amongst these was whether the "traded on a trading venue" (ToTV) concept to determine the scope of the transparency requirements for fixed income and derivative instruments was appropriate, alongside removing certain waivers such as SSTI, and replacing liquidity calculations with a qualitative and quantitative assessment to determine the liquid classes of financial instruments. Although it looks like the Government is generally supportive of these changes none have been tabled specifically. Instead, the Government confirms that FCA should be responsible for recalibrating the scope and setting the firm-facing transparency requirement and states that pre and post trade transparency regime for fixed income and derivatives markets will be delegated to the FCA. There will therefore be more to come on this; a marathon rather than a sprint. In his speech, Mr Schooling confirmed that the FCA will be consult on returning the responsibility for setting large in scale (LIS) thresholds for exchange traded derivatives to trading venues. By way of contrast, the EU proposed shortening and harmonising publication deferrals for non-equity post trade reports to the public, as well as removing the discretion of national competent authorities to permit post trade reports for non-equities to be deferred for four weeks.

Commodity Derivatives

• Amending the definition of commodity derivatives: No end conclusion on this one. The Government intends to carry out further analysis to ensure that the regulatory perimeter under FSMA and commodity derivatives regime are both clear and coherent.
• Inclusion of economically equivalent over-the-counter (OTC) contracts: The Government agrees that economically equivalent over-the-counter contracts should not be automatically within scope of the commodity derivatives position limits regime. This change will be taken forward as part of the broader amendments to the position limits regime.
• Position limits regime: The Government plans to revoke the requirement for position limits to be applied to all exchange-traded contracts, and to transfer the setting of position limits from the FCA to trading venues. The FCA is to be given discretion to determine which contracts trading venues will be required to set position limits on. The Government will also give the FCA the necessary powers to establish a framework to support trading venues in setting position limits.
• Ancillary activities test: The Government plans to introduce secondary legislation to revoke the current ancillary activities test (to near everyone's relief given its complexity), re-introduce the “commodity dealer exemption” and remove the annual notification requirements. This would represent significant improvements to the current regime.

Market data

• Consolidated tape: The consultation proposed developing a consolidated tape for fixed income markets before developing one for equity markets. The consultation proposed legislative changes to legislation to allow a private sector tape to emerge. The response states that the FCA should be responsible for setting the requirements for consolidated tape providers and that the FCA will look into how best to enable the development of a consolidated tape for any asset class and for either pre- and post-trade data. The UK is focused on private sector competition in providing the consolidated tape, and on FICC asset class. At the EU level there is a different emphasis on a single consolidated tape provider.

Our Divergence Tracker provides a summary of UK/EU divergences, by identifying the changes between the UK and EU approaches to key regulations.