A Fork in the Road: the OTF-SI Decision Process
For any investment firm operating a single-dealer bond or swap ECN in Europe, MiFID II raises a life-altering decision – whether to become an organized trading facility (OTF) or a systematic internalizer (SI). Given the way MiFID II is worded, that choice has far-reaching implications. And, since Article 20 of MiFID says, “Member States shall not allow the operation of an OTF and of a systematic internaliser to take place within the same legal entity,” this is very much an either-or decision.
The most important aspect of MiFID’s definition of an OTF is its prohibition against the operator using its own capital in executing trades. Thus the OTF simply becomes an order matching engine, where customers and other dealers can enter bids and offers. Given that structure, the OTF operator has almost no control over the liquidity available on its facility, particularly in periods of high volatility.
Since today’s dealer ECNs are mostly an opportunity for the dealer to corral order flow, becoming an OTF completely disrupts that model. The only trading allowed by an OTF operator is matched principal trading, defined as “a transaction where the facilitator interposes itself between the buyer and the seller … in such a way that it is never exposed to market risk throughout the execution of the transaction, with both sides executed simultaneously, and where the transaction is concluded at a price where the facilitator makes no profit or loss, other than a previously disclosed commission, fee or charge for the transaction.” Otherwise, the OTF operator becomes a mini-exchange operator, reliant on transaction fees for revenue.
MiFID defines a SI as, “an investment firm which, on an organised, frequent systematic and substantial basis, deals on own account when executing client orders outside a regulated market, an MTF or an OTF without operating a multilateral system,” and further defines frequent systematic basis as, “measured by the number of OTC trades in the financial instrument carried out by the investment firm on own account when executing client orders.” A substantial basis is “measured either by the size of the OTC trading carried out by the investment firm in relation to the total trading of the investment firm in a specific financial instrument or by the size of the OTC trading carried out by the investment firm in relation to the total trading in the Union in a specific financial instrument.”
This definition is somewhat similar to the Volcker Rule (VR) definition of market making, and is equally vague. One thing to note is that the measurement of substantial is based on the ratio of customer-facing trades to all trades, which is one of the VR market-making metrics. So, one obvious first question is whether a national market regulator, or even ESMA, can revoke a firm’s SI status if it doesn’t maintain the frequent systematic and substantial dealing in specific financial instruments, and even whether the SI status applies to particular instruments, classes of instruments, or to the category covered under the OTF definition.
Making the Choice
As firms decide what to do with their ECNs, there are several criteria to consider. Overlaying all the criteria is the understanding that European markets are changing in many ways, only some of which are due to regulation. Two of the impending changes:
- Market volatility – the obvious economic and political split between the northern and southern tiers of Europe will most likely lead to increased market volatility, if not social unrest. In addition, any bond defaults that occur will have unknown ripple effects. Coupled with the long-awaited Fed actions to raise US interest rates, we should expect the next twelve months to be dramatic times in European, and global, markets.
- Market liquidity – as firms monitor their capital and expenses ever more vigilantly, more and more of them decide that being a liquidity provider in all markets under all conditions is not a good business model. Whether they exit the market-making function entirely or restrict it to certain products or customer sets, these actions are drying up liquidity globally. For the buy side, this presents the frightening possibility that they will need the most liquidity exactly when it is the least available.
With those changes in mind, here are some of the criteria firms are considering in making the OTF-SI decision.
What kind of relationship do we have with customers? Over the last ten years trust between the buy side and sell side has been severely damaged. Part of this is due to the natural tension involved in principal transactions, but much of it has been due to some rather unscrupulous actions by many global banks. In the new world, the buy side is very focused on the role their counterparties are playing, so firms currently operating ECNs will have to have a very clear understanding with their customers as to the value they bring to either of these new relationships.
What markets do we want to focus on? This question applies to both products and customer sets. It depends on a host of other questions. What customer sets do we have good relationships with? What countries are we well established in? What markets are our competitors exiting? What products do we have expertise in? What products will have the most activity in the future? Where can we combine offerings to maximize our advantage? All these questions require you to have some view of how the markets will evolve over the next five years, so they are very much a bet on the future.
What kind of risk appetite do we have? Being a liquidity provider in the new Europe is very definitely not for the faint of heart. Everyone who isn’t aware of that already will soon be educated in a painful way. As liquidity providers exit more and more markets, spreads will widen and the cost of accessing liquidity will go up. However, even if market-making becomes more profitable, lax risk management will carry a huge burden. In particular, for those who choose to become an SI, commitment to the market through thick and thin will be a regulatory requirement.
What kind of relationship do we have with our regulators? MiFID says that the regulation of market-makers is a national responsibility, but there is no clear guidance for those regulators as to what constitutes appropriate commitments on the part of either an OTF operator or SI. As a result, making the decision will be heavily dependent on understanding how your local regulator will evaluate your performance. Getting a nasty surprise in the form of a revocation of your status could ruin your whole year.
What is our corporate culture? This criterion may have the most impact on the success of either option. Operating an OTF requires a completely different corporate culture from being a SI. The keys to success as an OTF are attracting both customers and dealers, a mind-set that exchanges are used to but dealers are not. Making a SI successful requires a culture much more akin to the traditional dealer, but with more regulatory oversight and responsibilities. Whether your corporate culture can adapt quickly to market changes may actually dictate more than which option you choose – it may dictate your success overall.
In the end, the OTF-SI decision comes down to a fork in the road, with a lot depending on which choice you make. Looking down each fork as far as you can is surely the first step, and having some form of roadmap, however blurry, is another step, but there is no doubt that each fork represents a very different set of relationships with customers, competitors, and regulators. Understanding how those relationships are changing, looking at them from a variety of viewpoints, and making a commitment to a new set of relationships are all parts making a successful choice. Which fork will you choose?