Market Infrastructure Regulation, Data Transparency & Liquidity Fragmentation

Due to COVID-19 pandemic, the European Securities and Markets Authority (ESMA), the EU’s securities markets regulator, has granted all stakeholders four more weeks to answer some of the ongoing consultations.

European Market infrastructure: The need for Transparency.

MiFID II saw the introduction of a multitude of new electronic trading platforms. Market electronification has been a long-standing trend and market regulation allowed new actors to emerge. MiFID II framework comprises a variety of regulated trading venues (TV): it includes historical regulated markets (RM), Multilateral Trading facility (MTF), Organized Trading Facilities (OTF) with discretionary execution and Systematic Internaliser (SI).

One of MiFID II goal was to encourage market participants to move over-the-counter (OTC) bilateral trading activity onto trading venues as pictured above. Indeed, one of the hot spots revealed by the Great Depression in 2009 was the lack of transparency on transactions, leading to systemic risk. Regulators tried to reduce the importance of the “shadow banking” especially on the OTC derivatives market. Core principles shared by Regulation in Europe (EMIR, MiFID and incoming SFTR) and Dodd Frank in the US were the same: mitigate systemic risk, protect investors against market abuse and provide more transparency.

How to achieve Transparency?

Transparency in financial markets relies on two pillars:

  1. the first one allows efficient price formation thanks to pre-trade transparency: the disclosure of information related to quotes;
  2. the second one – on which we will focus – is the disclosure of executed transactions: post-trade transparency.

Under MiFID II, all trades, regardless of whether they are executed on trading venues or OTC, must be immediately included in a trade report that contains the volume executed and price. This report needs to be published for:

    • trades on a trading venue, by the market operator;
    • trades with a systematic internalisers, by the SI;
    • OTC trades – by the seller.

For that purpose, investment firms rely on an Approved Publication Arrangement (APA) which is a company authorized by a regulator to provide the service of publishing trade reports on behalf of investment firms.

Below, important dates to understand slow progresses on this topic in Europe:

What needs to be improved to meet this ambition?

  1. High-level of data quality

Due to an inherent lack of standards and inadequate OTC trade reporting rules, data provided by TVs and APAs is of insufficient quality. Each TV and APA source operates a different model and pictures the activity differently. This prevents users to accurately consolidate data, distinguishing the collective, accessible liquidity across the underlying markets.

Market participants pointed out that the quality of the source data is poor with off-venue trades, which are often inaccurately reported (in many cases, multiple times or not at all).

  1. A will: easily available to the public, free of charge

ESMA stated that in a recent Q&A on the matter that market data needed to be made available free of charge to users 15 minutes after publication. This is very useful, especially to assess execution quality across asset classes to the standard execution price. This is something required for investment firms under MiFID II.

Though, there is a significant number of Trading Venues that currently do not make 15 minutes delayed data free of charge. Some players charge for such delayed data in many different direct or indirect ways – for example, providing them only if a leased line is implemented with the provider.

In addition, some TVs and APAs are making Data user agreements really far-fetched, making legally complicated to use and consume historical data.

  1. Machine-readable data

Such data is often not provided in a truly machine-readable format – data made available in image format in some cases! In addition, some trading venues and APAs make data available only for a very short period and subsequently delete it. As a result, it is either impossible or very onerous to consume data. It is these failings that prevent underlying investors from truly benefitting from the data as an input into best execution analysis.

The data made available free of charge needs to be published in a similar format as real-time data published on a reasonable commercial basis. If you try to register on some well-known inter-dealer broker you can experience by yourself that you can only access  a limited  portions  of  the data e.g. ISIN-by-ISIN searches – when you know that there are c. 35 milions ISIN created it makes it unusable.

Generally speaking, the current situation does not meet the requirement of making data available free of charge and easy-to-use or usable at all.

  1. Limits of the data made available

The overall level of real-time post-trade transparency appears to be very limited. Not all trading venues are currently (fully) complying with the requirement to make post-trade data available free of charge 15 minutes after publication. This significantly limits the analysis ESMA can perform. ESMA acknowledged the comments made by many stakeholders that a four-weeks delay for the publication of a transaction provides information to market participants which is of limited use.

Indeed, timing of disclosure (real time or deferred) is a function of security and size: large or illiquid trades can benefit from waiver and deferrals. These types of transactions are thus made transparent from t+2 up to 4 weeks later.

What is done in the US? A possible inspiration for Europe

For OTC derivatives, transactions executed on-SEF (Swap Execution Facility – Trading Venues that are deemed equivalent to MTF by ESMA) have their full size reported at T+1. These volumes are aggregated at instrument level, not at the transaction level. As a consequence, it allows market participants to know at T+1 volume traded and execution price.

According to Clarus, an US-based fintech consuming these public data, the suppression of these deferrals is of key importance for monitoring total sizes traded, given that 43% of notional is executed above the block threshold.

Trading Venues need to be allowed to report their full volumes so that market participants can compute their respective market share and control the statistics are accurate. More simplicity would be welcomed since these deferral regimes clearly underpinned the aim to get transparency on MiFID II data.

An unwanted consequence: the rise of market data costs?

If knowledge is power, thus access to information and ability to use data is of a key importance. Transparency enhancement and data available free of charge to the public can surely affects some important actors in the financial market: data vendors.

Due to increase competition, trading venues are trying to address falls in trading revenues. Regulated Markets are increasing their revenues from the sale of market data in the context of a long-term downward as a result of market fragmentation. At the same time, there is nothing to counterbalance this dynamic. There is no real competitive constraint preventing exchanges to raise prices due to the reliance of market participants on market data over which they hold a monopoly of supply.

This dominant position of Regulated Markets may appear counterintuitive. With the rise of many new electronic trading platforms, greater fragmentation of liquidity has reinforced the importance of algorithmic trading, which relies on the primary exchange as the most important source of data to form a complete picture of the market on which algorithms can base their trading decisions. In addition, each new trading platform is likely to depend on market data from the primary exchanges, whether for the purposes of price formation or risk controls.

To conclude, market data costs has increased for most market participants. For instance, the Association of Proprietary Traders that represents 23 independent proprietary trading firms based in the Netherlands, reports a 40% fee increase in its total costs for the 2016-2019 period.

Data needs in general has exploded – not only in volume, but in velocity and variety. This includes market data, which has become more complex. The increasing number of venues, the fragmentation of liquidity and the technological improvements have introduced many nuances in the content that venues now produce and sell.

Market regulation has an impact in the evolution of data market use. The focus on best execution has meant that market participants have been obliged to consume more data, reducing price elasticity and reinforcing dominant position of some market data providers. In its latest consultation on MiFID II/MiFIR the European Commission raised concerned on this specific topic but new regulation is not for tomorrow.