4. Organised Trading Facilities (OTFs)
Who should read this chapter?
This chapter is relevant for RIEs and authorised firms who operate, or may seek to operate, an OTF.
It may also be of interest to direct and indirect users of OTFs such as investment banks, interdealer brokers, high frequency traders, and investment managers.
MiFID II introduces a new category of trading venue called OTFs. An OTF is a multilateral system that is not a RM or MTF. Within an OTF, multiple third-party buying and selling interests in bonds, structured finance products, emission allowances or derivatives are able to interact in a way that results in a contract. Equities are not permitted to be traded through an OTF.
This section addresses issues around this new category of trading venue, and discusses the impact of general rules on OTFs and of rules specific to OTFs. We present proposals for Handbook changes which turn MiFID II provisions on the trading processes of OTFs into rules, and signal where there are relevant directly applicable requirements covering such issues as trading transparency and requirements for algorithmic trading. These are contained in a proposed new Handbook module, MAR 5A.
The introduction of OTFs means that many transactions currently categorised as off-venue will come within a multilateral trading environment. This should increase overall market transparency, reduce the prevalence of opaque market models and products, and increase the quality of price discovery, investor protection and liquidity.
OTFs are an important addition to the EU market infrastructure, and will help market participants to meet MiFID II’s platform trading obligation for derivatives. Where ESMA deems that a derivative instrument subject to the clearing obligation – introduced in Regulation (EU) No 648/2012 on OTC derivatives, central counterparties and trade repositories, sometimes referred to as the European Markets Infrastructure Regulation (EMIR) – is sufficiently liquid for the trading obligation to apply, OTFs will provide an additional venue type on which to trade those instruments.
We also expect instruments not subject to the trading obligation will be traded through OTFs, for example via market making schemes. A key difference between OTFs and MTFs is the ability and requirements on an OTF to use discretion when matching buying and selling interests, provided the use of discretion is in line with fair and orderly trading and with best execution obligations to clients. This helps to provide liquidity and price transparency in asset classes that have traditionally been less liquid.
This should help facilitate competition in these markets, where execution has traditionally been between large market participants, dealing in large sizes. Bringing over the counter (OTC) contracts on venue should bring better price transparency.
General Rules for OTFs
The requirements that apply to OTFs and their transactions are generally the same as the requirements for MTFs. This is because MTFs and OTFs are similar multilateral systems that bring together third-party buying and selling interests in financial instruments in a way that results in a contract (see article 4(1)(23) of the recast MiFID).
As with MTFs, under article 18 of the recast MiFID, 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. This is discussed further in Chapter 6.
MiFID II will also expand the scope of algorithmic trading systems and controls, which are covered in more detail in Chapter 8.
MiFID II is ‘technology neutral’ and permits any trading protocol to be operated by an OTF, provided it is consistent with fair and orderly trading and the exercise of discretion.
OTFs are also required to establish and maintain effective arrangements and procedures to enable the regular monitoring of compliance by the members. OTFs must monitor the transactions undertaken by their members using the venue’s systems to identify breaches of the rules, disorderly trading conditions or conduct that may involve market abuse. They are obliged to do so continuously and to take action if they identify such activity.
Investment firms operating an OTF will also be subject to similar financial resources requirements to investment firms operating MTFs as set out in CRD IV (comprising: the Capital Requirements Regulation (CRR), Regulation 575/2013, and the Capital Requirements Directive (CRD), Directive 2013/36/EU). These rules are implemented in the Prudential sourcebook for Investment Firms (IFPRU) and the directly applicable CRR, and further guidance on the perimeter between MiFID and CRD IV is included in PERG 13.6. As with investment firms currently operating MTFs, investment firms operating an OTF will also have to meet the Recovery and Resolution Directive (BRRD), Directive 2014/59/EU. This requires firms to produce recovery plans and also to submit data relevant to resolution. These rules are in IFPRU 11.
Rules specific to OTFs
In relation to RIE-operated OTFs (rather than those operated by firms) the Treasury has consulted on amending the RRRs to insert new paragraphs 15-17 to the Schedule (see chapter 2, footnote 7) to reflect MiFID II requirements relevant to RIE-operated OTFs. We propose including these in REC 2.16A.
However, RIEs operating OTFs should still take note of the FCA Guidance set out in MAR 5A, as it will be relevant both for firms required to comply with MAR 5A Rules and to RIEs required to comply with RRRs. RIEs should also take note that the rule in MAR 5A.3.8, concerning conduct of business obligations of an OTF operator, applies to them as if they were a firm
OTFs are also subject to specific provisions that cover the OTF business model and the transactions executed through it. These provisions are in article 20 of the recast MiFID. We propose to implement these requirements in MAR 5A.3.
In particular, an OTF operator is required to use discretion when deciding when to place or remove an order on their OTF, and whether or not to match a specific client order with other orders available in the system, subject to best execution obligations.
The investment firm or market operator running an OTF must not allow client orders to be executed against the proprietary capital of the firm or any entity that is part of the firm’s legal group. The only asset class for which the use of proprietary capital is permitted is illiquid sovereign debt instruments.
An OTF may engage in matched principal trading where this has been agreed by the clients. This is not permitted for derivatives subject to the EMIR clearing obligation.
OTFs are also restricted in the way that they can interact with SIs. The same legal entity cannot operate both an OTF and an SI. An OTF is also prohibited from interacting with an SI if this allows any quotes or orders in the SI to interact. This prohibition also applies to quotes and orders in another OTF, when two OTFs are interacting.
We propose to add an additional chapter to the FCA Handbook, MAR 5A, containing the rules that apply specifically to OTFs. We propose that MAR 5A also contains some of the more general requirements that apply to MTFs, thus duplicating some of MAR 5. Although some investment firms will operate both MTFs and OTFs, they are distinct venue types. To make the Handbook as useable and accessible as possible for all OTF operators, we propose that MAR 5A is inserted as a separate chapter.
Q5: Do you agree with our proposals on how to implement OTF rules in MAR 5A? If not, please give reasons why