Trade Surveillance: MiFID 2 Revisited

The latest MiFID makes trade surveillance a priority. We drill down and help you get your head around it

Recently we published a lengthy blog covering MiFID 2, the second iteration of the European Union’s Markets in Financial Instruments Directive. In it, we gave the view from 40,000 feet. This week, we’re zooming in on trade surveillance: a subject MiFID 2 pays great attention to, and a subject near and dear to any compliance team’s heart. But first, some background.

Increased trade surveillance is at the heart of MiFID 2 because investor well-being is at the heart of EU financial regulatory thinking. That means greater transparency, and in the age of Big Data that means capturing as much data as possible for all things trade related. The more detailed the data trail for a given trade, the better regulators can determine whether or not the individual investor got the best deal possible, or best execution. More on that later.

While MiFID 2 creates requirements and obligations for the majority of market participants, the rights of the individual investor remain the primary regulatory driver. This focus on the individual holds across much of EU thinking, and is as reliable predictor as any of its actions in the financial sphere and beyond.

The devils in the details
There are 28 regulatory technical standards, or RTS, that the European Securities and Markets Authority issued in relation to MiFID 2. These RTS are the legalese of EU financial law turned into working technical standards the industry can use in practice. We’ll focus on the ones that deal specifically with trade surveillance, as well as highlight how MiFID 2 will impact the trade surveillance function in general.

And for the sake of simplicity, we’ll refer to all trade surveillance impacts as stemming from MiFID 2, though its sister regulation, MiFIR, or Markets in Financial Instruments Regulation, is equally at work.

1. MARKET STRUCTURE REBOOT
MIFID 1 created multilateral trading facilities, or MTFs, which were supposed to be alternative trading venues, i.e., alternative to the big exchanges, like the London Stock Exchange.

MTFs were designed to be a boon to investors because more exchanges would mean more competition. MTFs did increase competition but also inadvertently caused market fragmentation, pushing a significant proportion of fixed income, fixed-income derivatives, and other over-the-counter securities off organized venues. Naturally, this decreased transparency. It also interfered with price discovery.

MiFID 2 tries to remedy this by requiring that all organized trading take place on regulated trading venues; by definition, these are regulated markets, or RMs, as well as MTFs. RMs and MTFs provide similar trading functionality, but an RM can’t be operated as an investment service or investment activity, unlike an MTF. Further, any trading done on these RMs or MTFs must take place via systematic internalization, or SI. Systematic internalization is a complicated way of saying market maker. Organized trading may also take place on an organized trading facility, or OTF.

There’s a lot going on here. Market complexity has vastly increased from MiFID 1. First, it’s expected that MiFID 2 will result in more fixed income securities moving back onto organized venues. Second, in terms of trade surveillance there will be, if not necessarily more trading to surveil, more trading venues to surveil, each with its own very specific and very technical structural differences. Compliance teams should therefore be on the lookout for software that integrates trading data across markets, which can provide a view of market abuse carried out across external and internal trading.

2. ALGORITHMIC TRADING ENGINES/RTS 6 
MiFID 2 draws a particular bead on algorithmic trading engines, or algos. These are the bundles of code that power automated, or algorithmic, trading. Like the idea of driverless cars, the idea of automated trading programs can make people nervous. In this case, regulators. Thus, moving forward, firms that employ algos in their trading operations must:

• Possess systems and controls that ensure trading systems are resilient, have sufficient capacity, enforce trading thresholds limits, and prevent outcomes that could mean a disorderly market.
• Have in place systems and controls capable of assessing and monitoring the suitability of those receiving the service, if the firm is providing direct electronic access to a trading venue.
• Ensure that compliance teams have a thorough understanding of how their algorithmic trading systems work, including the algos themselves.
• Self-assess their algo controls yearly, including stress testing to ensure compliance systems can hold up during market stresses or periods of increased order flows.
• Require their traders to monitor the firm’s algorithmic trading in real time. Yes, that’s real-time monitoring of automated trading.

Automated trading is ubiquitous today. What firm doesn’t have some algos running at least in the background of their trading operation? Compliance teams will therefore need software that can, very simply, do all of the above. More broadly, compliance software should have targeted detection abilities with available alerts, good trading-visualization capabilities, comprehensive supervision support, and seamless integration with all existing internal and external firm systems.

3. TELEPHONE/EMAIL ORDER RECORDS
As quaint perhaps as a requirement for this sounds, financial business is still conducted over the telephone. And it’s no secret that email trails have gotten plenty of individuals and their firms into trouble. MiFID 1 already required record keeping for all order records relating to email and telephone communications. MiFID 2 adds that the order records be sufficient “to ascertain that the investment firm has complied with all obligations, including those with respect to clients or potential clients and the integrity of the market.”

Compliance teams should look for a platform with inherent or third-party plug-in capabilities that can analyze telephone and email communications and automatically uncover risks, underlying intent, and market abuse. Software should have the ability to reveal MiFID 2 breaches within telephone and email communications data as they relate to customers, counterparties, and the trading floor. Well-designed software can detect signs of aggression, avoidance, collusion, deception, pressure, quid pro quo, apologies, boasting, rumor, and more.

4. BEST EXECUTION/RTS 27 AND 28
Implemented under MiFID 1, MiFID 2 takes the concept of getting the best possible trade results for investors, or best execution, to the next level.

In short, firms must do everything in their power to obtain the best result for their clients when executing orders. No less than 65 data points will need to be recorded for trades, up from 24, with that information stored for five years. Details must include price, costs, speed, likelihood of execution and settlement, size, and nature. Trading venues will be required to provide quarterly reports on the quality of client-trade execution. Ultimately, banks and brokers must be able to prove their customers got the best deal: whatever route through whatever exchanges and expediters they chose for a trade to travel.

RTS 27 in particular homes in on pre- and post-trade transparency across RMs, MTFs, OTFs, and SIs, the idea being to capture OTC trading activity and increase transparency around the internalized order flow of investment firms. In the pursuit of this, RTS 27 mandates a series of reports and their required content and form. RTS 28 calls for even more reporting, mandating that for every trade financial firms record:

• Client type and class of financial instrument.
• Venue name and identifier.
• Volume of orders executed on each venue as a percentage of total executed volume.
• Number of client orders executed on each venue as a percentage of the total executed.
• Percentage of orders that were passive and aggressive.
• Percentage of orders that were directed to a specified venue by the client prior to execution of the order.
• Notification of whether it has executed an average of less than one trade per business day in the previous year in a particular class of financial instrument.

This is a lot of very specific data that needs to be tracked. For starters, compliance teams should look for software that has cross-market alerts. These alerts will indicate where a trade might be executed on another venue that would provide better pricing, and allow enterprise financial firms the ability to provide their clients with the best execution possible for a trade.

5. TRADE REPORTING/RTS 22
Almost all securities traded in the EU will now have reporting requirements, a significant change from MiFID 1. Particular focus has been placed on OTC derivatives. And any security considered to be liquid must now be traded on an approved venue, i.e., an RM, MTF, or OTF.

Finally, it must be stressed that any trade that involves a security with an underlying asset based in the EU is subject to MiFID 2, no matter where in the world the trader is based, where the trader is doing his or her work, or where the trader’s firm is headquartered.

You can run but you can’t hide
MiFID 2 was formalized by the European Commission in 2011, adopted by EU institutions in 2014, and delayed a year past its original launch date of January 2017 to January 2018—all to allow market participants reasonable time to make ready. MiFID 2 is a work in progress at many levels. Thankfully, the EU recognizes this.

And the slack continues. ESMA recently gave firms an extra six months to assign the unique identifier numbers all parties to trades are required to have under MiFID 2. Compliance departments should take this regulatory relaxedness and run with it, with the clear understanding it won’t last forever. At some point, EU regulatory bodies will begin cracking down and enforcing MiFID 2 in granular detail. Maybe when they get their own heads completely around it.