Markets for Financial Instruments
‘Markets for financial instruments’ is the general term for systems that offer multilateral trading with financial instruments. It comprises traditional stock exchanges and alternative multilateral trading systems which offer market-like trading facilities. Central provisions governing financial instruments can be found in Dir 2004/ 39 on markets in financial instruments (MiFID) as well as in the implementing directive (Dir 2006/73) and the implementing regulation (Reg 1287/2006).
Under the MiFID, markets in financial instruments are divided into ‘multilateral trading facilities’ (MTF) and ‘regulated markets’, the latter term being defined more narrowly than the former. Nonetheless, the concepts are strongly related which reflects the fact that both offer organized multilateral trading. The MiFID defines a regulated market as a multilateral system operated and/or managed by a market operator, which brings together or facilitates multiple third-party buying and selling interests in financial instruments—in the system and in accordance with its non-discretionary rules—in a way that results in a contract, in respect of the financial instruments admitted to trading under its rules and/or systems, and which is authorized and functions regularly (Art 4(1) no 14 MiFID). This definition is aimed in particular at the traditional stock exchanges in the EU Member States. Moreover, the term ‘regulated market’ is relevant for the regulation of capital markets more generally. Various directives refer to this definition, eg Art 9(1) Market Abuse Directive (Dir 2003/6), Art 1(1) Prospectus Directive (Dir 2003/71), Art 1(1) Transparency Directive (Dir 2004/109) and Art 1(1) Takeover Directive (Dir 2004/25).
The term ‘multilateral trading facility’ (MTF) is defined more broadly than the ‘regulated market’. According to Art 4(1) no 15 MiFID an MTF is a multilateral system, operated by an investment firm or a market operator, which brings together multiple third-party buying and selling interests in financial instruments—in the system and in accordance with non-discretionary rules—in a way that results in a contract. This definition not only comprises multilateral trading facilities that generate prices by matching buy and sell orders, but also so-called crossing systems which import prices in order to match and execute orders according to the imported prices. Furthermore, the definition does not distinguish between periodic and continuous trading facilities.
Apart from MTF and regulated markets, the MiFID regulates so-called systematic internalisers. Systemic internalisers are bilateral systems, ie counterparty systems, in which the system operator regularly becomes a contracting party of any transaction effected over the system. Even though these trading platforms do not offer market-like trading, they compete with multilateral trading systems for order flow. The MiFID defines a ‘systematic internaliser’ as an investment firm which, on an organized, frequent and systematic basis, deals on its own account by executing client orders outside a regulated market or an MTF (Art 4(1) no 7 MiFID).
Market systems with a central counterparty that does not act on its own account but merely as an intermediary which bears the counterparty credit risk in all transactions, are considered to be a multilateral system and not a systematic internaliser (recital 6 MiFID). Such a central counterparty improves the security of trading and the settlement of trades, but it does not change the multilateral character of the overall system because it is still necessary to find another investor as a party to a transaction.
2. Developments relevant to regulation
The MiFID which succeeds the 1993 Investment Services Directive reflects the considerable developments in the capital markets during the period since 1993. It contains complex and differentiated regulation of different mechanisms and systems concerning trading with financial instruments which have developed over recent years. Technological advances as well as the growing impact of institutional investors caused by the progressing economic globalization have led to the development of off-exchange trading facilities, so-called alternative trading systems (ATS). These systems have become strong competitors of traditional stock exchanges and have posed new challenges to regulators. Recent information technology facilitates the installation of alternative trading systems. Their services range from simple websites where offers may be published to highly complicated trade mechanisms which organize trade such as stock exchanges. Complex systems which offer stock exchange-like market services are taking over the functions of traditional exchanges such as bringing together investors or allocating capital. ATS may be classified into three categories: (1) systems with market place functions which are open to numerous traders—they are especially close to traditional stock exchanges and are defined as MTF in the MiFID; (2) bilateral systems in which the operator becomes a counterparty to every transaction—they are widely covered by the definition of a systematic internaliser in the MiFID; (3) the remaining trading platforms, such as so-called bulletin boards which provide a website where investors can publish their offers. The remaining platforms are neither covered by the terms MTF or systematic internaliser nor specifically regulated in the [Directive|directive]]. Since transactions are—in general—executed outside the platform, the objectives of the MiFID, to protect investors (investor protection) and secure the functioning of the capital markets, are not affected by these platforms in the same way as by more complex systems which match the respective orders directly within the system.
3. Provisions of the MiFID
Regulated markets and MTFs are privileged over other trading systems, especially systematic internalisers: investment firms which execute transactions outside regulated markets or an MTF have to obtain the express consent of their clients prior to the execution (Art 21 (3)(III) MiFID). However, regulated markets are no longer favoured over MTF, despite the fact that stock exchanges in many EU Member States were so favoured before the enactment of the MiFID.
a) Regulated markets
Articles 36–47 MiFID include detailed rules for regulated markets, which are supplemented by the provisions on prudential supervision (esp Arts 48–55 MiFID). The Member States may only authorize those trading systems to become regulated markets which comply with the requirements in the MiFID (Art 36(1) MiFID). Moreover, the competent authorities of the Member States have to examine on a regular basis whether regulated markets comply with the MiFID provisions (Arts 36(2) ff MiFID). This includes the requirements for the management of the regulated market (according to Art 37(1), eg, the operators have to be of sufficiently good repute and sufficiently experienced) as well as organizational requirements (Art 39 MiFID). Organizational requirements include arrangements concerning the identification and management of conflicts of interest, risk management and system management.
Additionally, there are detailed rules on the admission of financial instruments to trading (Art 40 MiFID) as well as the suspension and removal of financial instruments from trading (Art 41 MiFID). The MiFID also contains rules regarding the access and the behaviour of market participants (Arts 42 ff MiFID). These rules set up a detailed framework that establishes which provisions regulated markets have to provide for themselves and that they have to monitor the behaviour of market participants and report significant breaches of their rules. The regulated markets also have to support the supervisory authorities in investigating and prosecuting market abuse occurring on or through the systems of the regulated market (Art 43 MiFID).
Detailed rules on pre-trade and post-trade transparency are to be found in Arts 44 and 45 MiFID. The two provisions are supplemented by the implementing Reg 1287/2006 and demonstrate the importance of transparency for capital markets. The transparency regime applies to both regulated markets and MTF (for the latter see Arts 29 and 30 MiFID), to systematic internalisers (Art 27 MiFID) and to all trading outside regulated markets and MTF (Art 28 MiFID). These provisions satisfy the need for a cautious transparency regime which balances the goal of far-reaching transparency with conflicting interests, such as, eg, avoiding free riding by other traders. These diverging interests have been accounted for by the possibility of deferred publication of large transactions and by the possibility of excepting systems whose market model is incompatible with the transparency requirements, such as, eg, price importing systems which cannot fulfil pre-trade transparency requirements.
b) Multilateral trading facilities (MTF)
Due to the similarity of regulated markets and MTF, many rules for both categories are the same or very similar. However, the density of MTF regulation is much lower than that of regulated markets. The operation of an MTF is defined as an investment service; hence, MTF operators have to adhere to the rules for investment firms. Additionally, Arts 14, 26, 29, 30, 35 MiFID include special provisions for MTF. These apply mostly to the trading on an MTF and the organization of an MTF, transparency obligations, the access to an MTF and information requirements vis-à-vis the participants. In particular, the provisions on pre-trade and post-trade transparency for MTF in Arts 29 and 30 MiFID are almost identical to the ones for regulated markets (Arts 44 and 45 MiFID, see above). Equally, the provisions on the access to regulated markets (Art 42(3) MiFID) and to MTF (Art 14(4)) are identical.
The provisions regarding the markets’ obligation to assure fair and effective trading provide more room for self-regulation than other provisions. The regulators found it to be most important that participants could receive the best possible execution of their order at any given time and size. The requirements for fair and effective trading may vary depending on whether professional participants or private investors trade on the system. Regarding the clearing and settlement of securities transactions, the operators of MTF are obliged to facilitate such procedures and inform the participants about their responsibilities. A consequence of self-regulation is the obligation of operators to monitor trading in their systems. This is supplemented by an obligation to support the supervisory authorities in their investigation and prosecution of market abuse.
c) Systematic internaliser
Like the operators of MTF, systematic internalisers are subject to the general provisions applying to investment firms. In addition, Art 27 MiFID contains special rules regarding the publication of quotes by systematic internalisers—specifically the current prices and quantities at which financial instruments can be bought or sold. Article 27 MiFID is an example of the challenges that this detailed regulation faces. On the one hand, with their aim of allowing for flexible solutions the provisions create the risk of potential manipulations. On the other hand, by significantly constraining systematic internalisers in their competition with other systems, the rules may induce market failures through their regulatory effects.
4. Supervision of capital markets and globalization
The increasing globalization and thus denationalization of securities trading creates challenges for national surveillance authorities regarding their competence to supervise capital markets. To determine whether a certain national authority is competent to supervise a certain securities trading system reference could be made to the domicile of the operator from which it pursues the activities that are to be regulated. Another approach could be to consider the place of the server which is used for the trading system. Such an approach, however, appears to be ill-suited as the server could be set up almost anywhere. A third approach would be to determine the location of the securities trading system according to the domicile of the participants of the trading systems. However, such an approach also appears to be incompatible with international capital markets and their cross-border trading capabilities as it would lead to a vast number of applicable state laws.
To solve the issue of competence, the MiFID provides for mutual recognition and home country control. Moreover, it contains detailed rules on the cooperation between EU/EEC Member States and their respective supervisory authorities. With regard to non-EU states the approach is usually more nationalistic. However, a certain degree of international cooperation between the respective supervisory authorities has been achieved by bilateral memoranda of understanding. Nevertheless, international cooperation has to be decisively intensified if internationally active securities trading systems are to be supervised and regulated effectively.
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