UK Wholesale Markets Review

Published Date
Mar 16, 2022
The U.K.’s policy approach to regulating secondary markets and investment firms, now that the U.K. has left the EU, has been confirmed by the government. Last year, HM Treasury conducted its Wholesale Markets Review proposing wide-scale changes across a raft of areas regulated under the EU’s Markets in Financial Instruments Directive (MiFID II) regime. Following completion of that consultation process, it has set out its policy, which areas will be amended and how. The U.K. originally “on-shored” MiFID II into U.K. laws with only minor amendments following its exit from the European Union. The new set of amendments aim to tailor this often unpopular and unwieldy package of European measures for the U.K. market. Changes are to be made in particular where the rules are considered to have had unintended outcomes, are duplicative or excessive or have curbed innovation.

These wide-ranging changes will impact many market participants. Some of the changes represent a fundamental shift, for example, those for the commodity derivatives markets, while others focus on reducing unnecessary burdens on market participants. All the changes demonstrate the U.K. government’s commitment to high standards and proportionate regulation.

There are certain areas that HM Treasury will not progress at this stage and will instead take forwards as part of other post-Brexit processes, and there are others which will be subject to further consideration. For the proposals that are being taken forward, implementation will be by legislation or pursuant to the Financial Conduct Authority’s rules. HM Treasury states that legislation will be brought forward when Parliamentary time allows. The FCA is expected to consult on its proposals for rule amendments in the first half of this year. In certain instances, where details are currently set out in legislation, but would sit better in regulatory rules, the government intends to legislate to delegate rule-making responsibility to the FCA, which it states will be part of the implementation of the Future Regulatory Framework review. These changes will be made via FCA rules once this delegation is completed.

This client note summarises the key changes arising from the Wholesale Markets Review and how they will be implemented.

Commodities Derivatives Markets and Position Limits

MiFID II requires the FCA to establish and apply position limits on the size of a net position in commodity derivatives traded on trading venues and economically equivalent OTC contracts. The limits apply to the size of a position that a person can hold, including any other positions held on behalf of that person by group entities. Trading venues are required to apply position management controls, including monitoring of open interest and obtaining information about the size and purpose of a position entered into, beneficial or underlying owners, concert arrangements and any related assets or liabilities. Trading venues also have power to require termination or reduction of positions and to require a person to provide liquidity back into the market at an agreed price and volume to mitigate the effect of a large or dominant position. The position reporting regime is intended to support the application and enforcement of position limits.

Over-the-counter, or non-venue traded (OTC), contracts that are economically equivalent to exchange traded commodity derivatives will be removed from the position limits regime. However, although this was considered, some other products will not be so excluded. This had been considered for derivatives that are not based on physical commodities and financial instruments that refer to commodities as a pricing element, but which are securities in their legal form. These will remain within the scope of the regime. The EU’s MiFID II Quick Fix, which was to be transposed into EU member state national laws by 22 February 2022, reduced the scope of the EU position limits regime to agricultural commodity derivatives and to critical or significant commodity derivatives traded on trading venues and their economically equivalent OTC contracts. Critical or significant derivatives are commodity derivatives with an open interest of at least 300,000 lots on average over a one-year period.

The position limits regime has proved among the greatest mistakes under MiFID II. The overly rigid regime led to grave difficulties for exchanges launching new products or which allowed the trading of less liquid contracts. Many such contracts are no longer traded in the EU or U.K. and were moved by trading venues to other countries in response to this poorly thought through and overly prescriptive EU legislation. HM Treasury has confirmed that, in line with the announcement of John Glen MP, Economic Secretary to the Treasury, on 23 November 2021, the requirement for commodities position limits to be applied to all exchange traded contracts will be revoked. The powers for setting position controls will be transferred from the FCA to the operators of trading venues, reflecting the status quo ante under MiFID I. The government will, however, give the FCA discretion to determine the contracts in respect of which trading venues will be required to set position limits. The FCA will also continue to set limits directly for OTC contracts, if needed. The FCA will have new powers to establish a framework to support trading venues in setting position limits.

MiFID II provides for certain exemptions from the position limits regime. Some extensions to these exemptions will also be implemented. A new exemption will be available for liquidity providers. Regulated firms will be allowed to facilitate hedging activity for a commercial entity, even where the hedged risk arises off-exchange or on a different trading venue. In parallel with these changes, the EU’s MiFID II “Quick Fix” amendments similarly introduced a narrowly defined hedging exemption for an authorised financial institution within a predominantly commercial group that trades on behalf of that commercial group. There is also an EU exemption for positions resulting from transactions undertaken to fulfil obligations to provide liquidity.

Separately, MiFID II resulted in a narrowing of some of the exemptions from regulation, particularly for energy and other commodity trading firms which are active in both physical trading and financial instrument trading. Such firms could only avoid regulation by showing that their financial activity was ancillary to the physical activity. This test was often difficult to apply and needed to become subject to so many exemptions and interesting interpretations to avoid its application and related unintended consequences. The U.K. government now intends to remove the “ancillary activities” test and re-introduce the old “commodity dealer exemption” for commercial firms. HM Treasury had originally proposed reintroducing the pre-MiFID II qualitative ancillary activities test. However, respondents to the consultation felt that such a change would introduce legal uncertainty. The requirement annually to confirm to the regulators that the threshold has not been reached is also being removed in the U.K.. Some changes of a similar direction have been adopted in the EU; the EU MiFID II “Quick Fix” amended the ancillary activities test to enable EU national regulators to combine a quantitative and qualitative assessment, based on guidance to be issued by the European Commission.

The U.K. commodities regime includes a bespoke regime for both oil market participants (OMP) and energy market participants (EMP), the requirements for which are set out in the FCA’s Handbook. It was proposed to remove those regimes, but this change will not now be implemented. HM Treasury had proposed subjecting firms under these regimes to the MiFID II requirements for commodity derivatives, unless they fell out of scope under the new ancillary activities test. HM Treasury and the FCA will review this further, including analysing how such changes could have unintended effects on how firms are authorised and the subsequent obligations that they must comply with.

Fixed Income and Derivatives Markets

MiFID II imposes a “trading obligation,” requiring mandatory on-venue trading for financial counterparties and non-financial counterparties where they engage in transactions in derivatives that: (i) have been declared subject to the clearing obligation under the U.K.’s European Market Infrastructure Regulation; (ii) are admitted to trading or traded on at least one U.K. trading venue (a regulated market, MTF or OTF) or a third-country equivalent trading venue; and (iii) are sufficiently liquid.

The scope of the derivatives trading obligation will now be further aligned in the U.K. with that of the separate clearing obligation (for mandatory central clearing) under U.K. EMIR. This will remove ambiguity where small financial counterparties are out of scope of the clearing obligation, but still subject to the DTO. The EU is adopting the same change.

In addition, subject to certain conditions, an exemption (presently in the DTO but not in the clearing obligation) for the termination or replacement of component derivatives in portfolio compression will be extended so as to also apply to the clearing obligation.

The FCA will be granted a permanent power to modify or suspend the application of the DTO, after it has consulted with the government. Market disruption was avoided by the FCA using its temporary transitional power to amend the scope of the U.K. DTO for Brexit, and HM Treasury believes that the FCA should retain such powers.

Finally, HM Treasury confirms that the pre- and post-trade transparency regime for fixed income and derivatives markets will be delegated to the FCA.

Legislation will be made to bring in these changes when Parliamentary time allows.

Trading Venues

Trading Venue for Smaller SMEs

The Wholesale Markets Review had proposed to introduce a new type of trading venue (or additional segment for existing trading platforms) tailored to the requirements of smaller SMEs. As an example, SMEs with a market capitalisation under £50 million was proposed as a category. Most respondents did not support the idea of a new SME specialist trading venue type, as it would potentially overlap with the existing SME Growth market category. HM Treasury will explore this proposal further in 2022 alongside the work on the U.K. listings regime. It remains committed to increasing firms’ access to the primary and secondary markets.

Lifting Restrictions Applicable to MTFs and OTFs

The MiFID II regime creates a number of at times artificial and overlapping categories—regulated market, multilateral trading facility, organised trading facility and systematic internaliser—and then prohibits various of these from performing activities of the others. HM Treasury intends to remove some of the business limitations that are imposed on MTFs and OTFs. The following will be implemented as part of the FRF review:

  • Allowing matched principal trading by an MTF, conducted under clear, transparent and nondiscretionary rules.
  • Enabling OTFs to execute transactions in packages involving derivatives and equities.

HM Treasury will be considering further whether conflicts of interest would be manageable if a Systematic Internaliser and OTF are operated within the same legal entity.

In addition, the FCA will provide clarification, following consultation, on the regulatory perimeter for trading venues, in particular MTFs, which will likely be in the form of regulatory guidance. The FCA will also develop guidance on the expected roles of market operators and participants during an outage, to further the aim of trading continuing during market outages.

Systematic Internalisers

Systematic Internalisers refer to firms which regularly execute transactions across their own books, rather than externally on trading venues. HM Treasury will proceed with reverting to a qualitative threshold to determine whether an investment firm must be authorised as a Systematic Internaliser, with the determination being made according to a firm’s market activity for a particular asset class. The existing quantitative threshold requires firms to undertake calculations that are calibrated at different levels for each asset class. To avoid the cost and administrative burden of carrying out and monitoring their situation versus these calculations, a lot of firms had, as a defensive measure, opted into registering under the Systematic Internaliser regime for all assets that they trade in. This change should allow for more appropriate registrations.

In addition, certain restrictions will be removed on mid-point execution across a Systematic Internaliser’s own book, provided that the Systematic Internaliser considers the extent to which their use of midpoint execution is consistent with their best execution obligations.
Both changes will be made by legislation. Amendments to the Systematic Internaliser reporting regime will be made by FCA rules.

Equity Markets

HM Treasury has confirmed that, as announced by John Glen MP, Economic Secretary to the Treasury, on 23 November 2021, the following obligations will be removed through legislation:

  • Share Trading Obligation: U.K. MiFIR currently requires U.K. investment firms to ensure that the trades they undertake in shares admitted to trading on a regulated market or traded on a trading venue take place on a U.K. regulated market, MTF, Systematic Internaliser or equivalent third-country trading venue. HM Treasury confirms that the STO will be removed. It was introduced to bring more trading onto lit markets and increase transparency. However, these objectives have not been achieved. The STO is based upon an historically EU concept and is not founded in international standards nor was it required under U.K. legislation prior to EU intervention. Notably, other key jurisdictions do not have a STO, including the U.S., Switzerland, Australia and Hong Kong.
  • Double Volume Cap: The unpopular “double volume cap” will be removed. Introduced with MiFID II, the DVC was intended to encourage trading on lit venues, instead of in dark pools. The DVC limits the amount of trading that can occur without pre-trade transparency by restricting the use of two of the waivers from the pre-transparency requirements: the reference price waiver and the negotiated price waiver. The limits are set at four per cent of all trading in an instrument on an individual trading venue, and eight per cent across all venues. Once the threshold is reached, the FCA may suspend the use of the waiver by all trading venues. HM Treasury confirms that the DVC will be abolished. However, the FCA’s power to limit the amount of trading without pre-trade transparency will be retained. The EU’s proposed changes to MiFID II include a proposal to replace the DVC with a single volume cap set at seven per cent of trades that are executed under the reference price waiver or the negotiated trade waiver.
Market Making Agreements

As part of the changes to be implemented under the FRF Review, the requirement for algorithmic trading firms with a market making strategy to enter into binding, written market making agreements with trading venues will be removed, including the need for both entities to have effective systems and controls in place to fulfil their obligations under the agreement. Most respondents supported this change.

Amending the Tick Size Regime

The MiFID II “tick size” regime establishes by way of legislation minimum increments by which prices for equity and equity-like instruments can change. The requirements are intended to mitigate against high frequency trading gaining execution priority by offering fractional price changes as this could lead to disorderly markets and negatively impact price formation.

The calculation of “tick sizes” is based on the liquidity of the most liquid market in the U.K./EU, without any consideration being given to the liquidity on non-U.K. and EU trading venues. The detailed MiFID II requirements on this previously unregulated area have resulted in numerous unintended consequences. In particular, the MiFID II package resulted in unnecessarily larger tick sizes for overseas shares. The regime will be amended, within the FCA rules, so that trading venues can follow the tick sizes applicable in the relevant primary market of a share, even where that share does not have its primary market in the U.K.. Trading venues will also be permitted to establish tick sizes for new shares until sufficiently robust data is available.

HM Treasury will consider further whether the setting of tick sizes for shares admitted to trading for the first time should be delegated to trading venues, with appropriate controls, instead of the FCA doing this, as was the outcome for position limits.

Market Data

Consolidated Tape

MiFID II introduced requirements for a “consolidated tape” for transactions in equity and non-equity instruments. It requires a CTP to collect post-trade information published by trading venues and approved publication arrangements and to consolidate this into a continuous live data stream made available to the public. No CT has yet been set up in either the U.K. or the EU.

HM Treasury sought feedback on the establishment of a fixed income consolidated tape. The government considers that the FCA should be responsible for setting the requirements for CT providers and will legislate to provide the FCA with the power to do so. The FCA will be able to decide how to enable the development of a CT for any asset class and whether it should cover either pre- and post-trade data or both. HM Treasury states that a fixed income tape is still its priority because the market is less concentrated and is mostly executed OTC. The U.S. has a version of a fixed income CT in the form of the Trade Reporting and Compliance Engine, which the Financial Industry Regulatory Authority developed to facilitate the mandatory reporting of OTC transactions in fixed income securities.

The EU’s proposed changes to MiFID II include a proposal to establish a CT, which would impose an obligation on trading venues to contribute market data directly and exclusively to the entities appointed by the European Securities and Markets Authority as the CT provider for each asset class. The asset classes will be shares, ETFs, bonds and derivatives. ESMA would be responsible for authorising and overseeing CT Providers.

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This content was originally published by Shearman & Sterling before the A&O Shearman merger