The Level 2 process for MiFID 2 and MiFIR (together MiFID II), which are expected to come into force by the beginning of 2017, is underway.

Which types of market infrastructure does MiFID II regulate?
Like MiFID, MiFID II sets out the regulatory framework and provides some of the rules for regulated markets (RMs) and multilateral trading facilities (MTFs). MiFID II introduces a new type of trading venue, the organized trading facility (OTF). Third-country venues will also be considered permissible trading venues under MiFID II where the Commission adopts a positive equivalence determination.

Why are OTFs relevant to thetrading of derivatives?
An OTF is defined broadly to capture all forms of organized trading in non-equities. In order to improve trading transparency in markets, OTFs will become subject to the same transparency rules and other core requirements as RMs and MTFs. These include new requirements in relation to systems, controls, circuit breakers and rules relating to minimum tick size (that is, the smallest increment by which the price of a financial instrument can move).

Are there any differences between the rules for OTFs and those for RMs and MTFs?
Yes. Unlike RMs and MTFs, OTFs are required to exercise discretion as to whether to place an order within the OTF, and whether to match specific client orders with other orders in the system they operate. Investment firms and market operators operating an OTF will also be subject to investor protection obligations.

Are there any restrictions on OTFs?
Yes. OTFs are prevented from executing client orders against the proprietary capital of the investment firm or market operator operating the OTF, or any entity that is part of the same corporate group and/or legal person.

What about matched principal trading?
An OTF will only be allowed to engage in matched principal trading in derivatives where the client has consented to the process. This excludes derivatives that have been declared subject to the clearing obligation.

In what circumstances will derivatives, which are currently traded OTC, have to be traded on an OTF?
MiFIR requires financial counterparties (as defined in Article 2(8) of the European Market Infrastructure Regulation (EMIR)) and non-financial counterparties to trade derivatives that are subject to clearing obligation on a trading venue. Non-financial counterparties are those that meet the clearing threshold conditions in Article 10(1)(b) of EMIR.

Are there other conditions for determining which OTC derivatives are caught?
The European Securities and Markets Authority (ESMA) is to develop regulatory technical standards specifying which of the derivatives which are subject to the EMIR clearing obligation should also be subject to the MiFID II trading obligation. ESMA will regularly monitor the activity in derivatives which have not been declared subject to the trading obligation. This will allow ESMA to identify cases where a particular class of contracts may pose systemic risk and to prevent regulatory arbitrage between derivatives which are subject to the trading obligation and those which are not.  

What are the requirements for the trading obligation to take effect?
In order for the trading obligation to take effect, the relevant derivative must be admitted to trading on at least one trading venue. In addition, there must be sufficient third-party buying and selling interest such that the derivative is considered sufficiently liquid to trade exclusively on the venue.

What is meant by “sufficiently liquid”?
When determining whether a derivative should be considered sufficiently liquid, the following criteria will be taken into account:

• Average frequency and size of trades over a range of market conditions, having regard to the nature and life-cycle of products within the class of derivatives.
• Number and type of active market participants, including the ratio of market participants to products/contracts traded in a given market.
• Average size of spreads.

It remains to be seen whether each of the criteria will be given equal weighting.

Are there any trading venues other than RMs, MTFs and OTFs?
Yes, Systematic Internalizers (SIs). These are investment firms which, on an organized, frequent, systematic and substantial basis, deal on own account when executing client orders outside an RM, MTF or OTF without operating a multilateral system. An investment firm can only be an SI where all three conditions for a frequent, systematic and substantial basis are fulfilled.

How is the frequent and systematic basis calculated?
The frequent and systematic basis is measured by the number of over-the-counter (OTC) trades in the relevant financial instrument carried out by the investment firm on own account when executing client orders.

How is the substantial basis calculated?
The substantial basis is measured by the size of the OTC trading carried out by the investment firm in relation to either the total trading of the investment firm or the total trading in the EU in a specified financial instrument.

What reporting obligations will SIs have?
SIs will be required to make public all firm quotes for both equity and non-equity financial instruments traded on a trading venue for which they are SIs and for which there is a liquid market.

How have reporting mechanisms been strengthened?
MiFID II extends the scope of transaction reporting requirements to all financial instruments to ensure that the requirements mirror those of the Market Abuse Directive. These are in addition to reporting obligations for derivatives under EMIR. The MiFID II obligations require central counterparties and counterparties to report post-trade counterparty and common data to a trade repository. A trade repository, an entity registered with ESMA, is mandated to report post-trade data to the competent authorities and make post-trade data public.

What about the submission of post-trade data?
Investment firms will be required to submit post-trade data to so-called Authorized Reporting Mechanisms (ARMs), who will report the details of transactions to regulators on behalf of investment firms to ensure the data is published in a way that facilitates its consolidation with data published by trading venues. Once published, data may be subject to consolidation or further onward reporting by Approved Publication Arrangements, ARMs and Consolidated Tape Providers.

What about transparency requirements?
Trading venues must make public current bid and offer prices and the depth of trading interest at those prices which are advertised through their systems for derivatives traded on a trading venue. The requirement also applies to actionable indications of interests. Trading venues must make this information available to the public on a continuous basis during normal trading hours unless a waiver applies.

The following waivers permit deferred publication:

• Orders that are large in scale compared with normal market size and orders held in an order management facility of the trading venue pending disclosure.
• Actionable indicators of interest in request-for-quote and voice trading systems that are above a size specific to the instrument, which would expose liquidity providers to undue risk, taking into account whether the relevant market participants are retail or wholesale investors. Where a waiver is granted under this limb, the venue must make public at least indicative pre-trade bid and offer prices which are close to the price of the trading interests advertised through their system.
• Derivatives which are not subject to the trading obligation and other financial instruments for which there is not a liquid market.

In conjunction with deferred publication, competent authorities may:

• Request the publication of limited details of a transaction or details of several transactions in an aggregated form, or a combination thereof, during the time period of deferral.
• Allow the omission of the publication of the volume of an individual transaction during an extended time period of deferral.
• Regarding non-equity instruments that are not sovereign debt, allow the publication of several transactions in an aggregated form during an extended time period of deferral.
• Regarding sovereign debt instruments, allow the publication of several transactions in an aggregated form for an indefinite period of time.

When the deferral time period lapses, the outstanding details of the transactions and all the details of the transactions on an individual basis will be published (except sovereign debt volumes which may be published in aggregate form).

Jonathan Master is a partner in the Financial Institutions Group at Eversheds LLP. Andrew Henderson is a partner in the Financial Institutions Group at Eversheds LLP. He specializes in financial services regulation. Stefanie Sahla-Jones is an associate in the Financial Institutions Group at Eversheds LLP.