Singapore court’s cryptocurrency decision
Implications for cryptocurrency trading, smart contracts and AI
On 28 September 2015, the European Securities and Markets Authority (ESMA) published final drafts of 28 technical standards that it is mandated to produce under the Markets in Financial Instruments Directive II (MiFID II) and the Markets in Financial Instruments Regulation (MiFIR). At the time of their publication ESMA’s chairman, Steven Maijoor, said that the new rules would notably change the way Europe’s secondary markets function and that the magnitude of this change should not be underestimated.
The technical standards comprise of 27 regulatory technical standards (RTS) and one implementing technical standard (ITS). Technical standards are directly applicable in Member States and are legally binding. On their date of entry into force, they become part of a Member State’s national law with no implementation required. Therefore these documents are incredibly important and as mentioned above they should not be underestimated.
However, financial institutions face a mountain of paperwork in order to get to grips with these technical standards. The technical standards themselves run to 553 pages. In addition, ESMA’s final report and the associated costs benefit analysis that have been published alongside the technical standards are, respectively, 402 and 577 pages. Perhaps, this mountain of paperwork was to be expected as ESMA has made it very clear recently that its focus is shifting to supervisory convergence and that we are beginning to see the creation of, as is already the case in banking regulation, a new single rulebook.
Under MiFID, orders that are large in scale can benefit from a waiver from pre-trade transparency. The waiver is designed to protect large orders from adverse market impact and to avoid abrupt price movements that can cause market distortion.
MiFIR gives ESMA the mandate to draft RTS that will specify the size of orders that are large in scale compared with normal market size for each class of shares, depositary receipts, exchange traded funds, certificates and other similar financial instruments.
In its previous consultation ESMA proposed an approach for all equity and equity-like financial instruments to use the average daily turnover (ADT) as a proxy for liquidity and market impact and allowing, for each financial instrument, the calibration of orders which may be considered large in scale compared to normal market size.
The use of the ADT has been criticised by some for being too simplistic of a measure whilst others have supported its use on the basis that it is easy to calculate and is well understood by market participants. Whilst accepting that the ADT may not provide the best metric on which to establish the large in scale threshold in all circumstances, ESMA views it as a reliable metric positively correlated with liquidity which, from an operational perspective, can be collected and processed in a relatively simple way. Therefore ESMA has decided to continue to use the ADT.
It is also worth noting that in relation to the thresholds for each class of ADT ESMA has added a new ADT category for shares with an ADT of less than EUR 50,000 with a corresponding threshold of EUR 15,000. For exchange-traded funds ESMA has kept with its proposal for a single large in scale threshold of EUR 1,000,000. This will apply to all exchange-traded funds regardless of their liquidity or the liquidity of their underlying.
Article 5 of MiFIR introduces a mechanism that caps the amount of trading carried out under: (i) systems matching orders based on a trading methodology by which the price is determined in accordance with a reference price; and (ii) negotiated transactions in liquid instruments carried out under article 4(1)(b) of MiFIR. This double volume cap is designed to ensure that the use of waivers from pre-trade transparency does not unduly harm price formation. The double volume cap is to be implemented and supervised on the basis of ESMA publications regarding the volume of trading under the waivers and empowerment under technical standards enabling Member State competent authorities to obtain data for making such publications.
The volume cap applies on an instrument by instrument basis and in the final report ESMA notes that two situations can be distinguished. In the first case, the first volume cap is calculated on a trading venue by trading venue basis and is set at the level of 4% of the overall amount of trading across all trading venues in the EU. As for the second case, the volume cap is calculated across all trading venues operating under one or both of the relevant waivers and is set at 8% of the overall amount of trading across all trading venues in the EU. Both volume caps are measured against a rolling 12 month period with monthly updates published by ESMA as well as updates published twice a month in certain circumstances.
To ensure the publication of actual volume traded within waiver facilities, MiFIR empowers ESMA to produce RTS that specify the methods, by which it can collate the necessary information, calculate the actual volumes traded and publish the information.
On the frequency of the calculations and publications it is worth noting that ESMA’s original proposal regarding collecting data twice a month is maintained. Also, the proposal that trading volumes be requested not for the previous 12 months but only for the last 15 days is also maintained. Both proposals received no specific comments during consultation.
However, ESMA did receive some responses which questioned the use of “value” thresholds (number of units traded multiplied by price) and favoured using “volume” thresholds (considering only the number of units traded). In its response ESMA disagrees with the volume threshold approach arguing that price remains an essential element.
On the topic concerning the conversion of data into euros ESMA has noted some concerns that have been raised following its earlier consultation. With respect to financial instruments that are traded in only one single currency across the EU, the volumes to be used for the calculations and to be published will not be converted. For financial instruments traded in more than one currency across the EU, ESMA states that it will be necessary to convert the volumes executed in different currencies into one common currency so as to enable the computation of those volumes and make the required calculations. In such cases the volumes will be converted into euros. However, trading venues will not be responsible for the conversion of the volumes. In a revision to its original proposal data will be reported to competent authorities and ESMA using the original currency of the transaction and the conversion into euros will be managed centrally by ESMA.
The concept of a liquid market for non-equity instruments can be found in article 2(1)(17)(a) of MiFIR. If a market participant wishes to trade a non-equity instrument that is labelled as liquid, pre-trade transparency requirements come into force that require the details of the transaction to be published to the wider market.
On the basis of the definition in article 2(1)(17)(a) of MiFIR and the mandates to define the classes of non-equity financial instruments for which a waiver / deferral may be granted because there is not a liquid market for them, ESMA is required to specify the non-equity financial instruments or classes of financial instruments for which there is not a liquid market.
In its previous consultation ESMA proposed to use the Classes of Financial Instrument Approach (COFIA) as the basis for determining the liquidity of all non-equity financial instruments. This approach sought to segment non-equity financial instruments into specific sub-classes defined according to certain criteria like maturity and currency. On this basis such sub-classes (and all instruments belonging to those sub-classes) were deemed to be liquid or illiquid.
In its final report ESMA notes that generally stakeholder feedback was split on the use of COFIA. Whilst respondents, mainly from the buy-side and exchanges, supported its use other respondents, mainly from the sell-side, called on ESMA to reconsider using the Instrument by Instrument Approach (IBIA).
For the liquidity assessment of bonds ESMA has opted to apply the IBIA approach as it considers it strikes the right balance among flexibility, stability and operational manageability. Furthermore ESMA proposes that the liquidity of each bond is re-assessed at the end of every quarter. In addition, newly issued instruments will be deemed to be liquid according to their issuance size. A bond will be considered to be liquid until the application of the first assessment based on the trading activity recorded over a quarter. For bonds issued during the first two months of a quarter the classification of liquidity based on the issuance size will last until the publication of the results of the calculations at the end of that calendar quarter. For bonds issued during the last month of a quarter the classification of liquidity based on the issuance size will last until the publication of the results of the calculations at the end of the next calendar quarter. A table showing the applicable issuance size for each bond type can be found on page 97 of the final report.
ESMA has also decided to keep its consultation proposal to exclude transactions under EUR 100,000 from the calibration of the transparency exemptions. Some industry associations have already mentioned that they do not see an objective reason for this, as significant institutional trading takes place under this level and to have these transactions excluded will heavily skew the application of the transparency exemptions.
In the final report there is little of note on the key issue concerning the scope of algorithmic trading rules or the extent to which they extend to third-country managers accessing EU markets via direct market access.
However, ESMA does seem to have listened to respondents’ concerns about the need to ensure that algorithmic controls requirements are drafted in a way that allows for their proportionate application and there is also useful clarification that the segregation of governance functions does not necessarily imply additional personnel.
ESMA has also adopted a more accommodating stance on how testing obligations can be fulfilled, whether in-house, via a venue or via a third party vendor. In relation to testing ESMA has clarified that pure investment decision algorithms that are executed by non-automated means are out of scope of the algorithm testing requirements contained in MiFIR.
Regarding stress testing ESMA has made a number of changes to its proposals, in particular by clarifying that any stress tests should be undertaken in such a way that they do not affect the production environment, and by limiting the number of mandatory test scenarios to only two. ESMA has also changed its approach, agreeing with respondents that annual stress testing should not be based on the number of algorithms running simultaneously but on the volume of messages managed by the system.
Under MiFIR, central counterparties (CCPs), trading venues and clearing members shall ensure that transactions in cleared derivatives are submitted and accepted for clearing as quickly as technologically possible. MiFIR mandates ESMA to develop draft RTS in order to specify the minimum requirements for systems, procedures and arrangements to ensure straight-through processing (STP), taking into account the need to ensure proper management of the operational or other risks.
In its final report ESMA notes that many respondents to its consultation commented that mandatorily cleared and voluntarily cleared OTC derivatives should not be distinguished, when the decision to clear them is known at the time of execution. ESMA has agreed with this view and has amended the relevant RTS so that the distinction is whether cleared OTC derivatives were traded on a trading venue or not, and not to distinguish mandatorily between cleared and voluntarily cleared. Also, the proposed 10 second timeframe in which to send trades to the CCP remains unchanged.
Article 57(1) of MiFID II requires Member States to ensure that their competent authorities establish and apply position limits on the size of a net position which a person can hold at all times in commodity derivatives traded on trading venues and economically equivalent OTC (EEOTC) contracts.
One of the main purposes behind this new requirement is to prevent market abuse and article 57(3) MiFID II requires ESMA to develop draft RTS that determine the methodology for the calculation that Member State competent authorities are to apply in establishing the spot month position limits and other months’ position limits for physically settled and cash settled commodity derivatives based on the characteristics of the relevant derivative.
Interestingly, ESMA is keeping with its consultation proposal that position limits in the spot month should be based on deliverable supply. However, it has reconsidered its view on position limits for other months which will now be based on total open interest. Also, ESMA has now proposed stricter limits for Member State competent authorities who will now have to set limits in a band of 5% to 35% (of deliverable supply or open interest) rather than the originally proposed 10% to 40%. ESMA states that this is balanced with a more accommodating approach to new or illiquid contracts.
To prevent avoidance of position limits on exchange-traded derivative contracts by persons entering into OTC contracts instead, article 57(12)(c) of MiFID II requires ESMA to determine the criteria by which an OTC contract is judged to be economically equivalent to an exchange-traded derivative that is traded on an EU trading exchange. Whilst noting that respondents to its consultation had differing views concerning the scope of EEOTC contracts it has maintained the essence of its proposed definition whilst further refining it. The EEOTC is defined as follows: a contract which has the identical contractual specifications and terms and conditions, excluding post trade risk management arrangements, as a contract traded on a trading venue.
Articles 17 and 48 of MiFID II introduce requirements on investment firms pursuing a market making strategy and trading venues where market making activities are undertaken using an algorithmic trading technique. In particular, article 48(2) of MiFID II places an obligation on Member States to require that regulated markets have in place written agreements with all investment firms pursuing a market making strategy on them.
The final draft RTS that ESMA has produced has been revised to address most of the concerns that were raised during the consultation. In particular, the definitions have in some cases been clarified and been moved to the relevant provisions. In addition, the references to the time periods on which a market making strategy should be observed or monitored have been aligned.
On the important issue of identifying market making strategies ESMA agrees that it is the investment firm’s duty to notify the venue if it intends to pursue this type of strategy. However, if the venue identifies such a strategy without prior notification, it has to contact the relevant investment firm to sign a market making agreement. Where the investment firm declines to sign the agreement or to disable its strategy, the venue may report an infringement to its competent authority.
Another important point is that ESMA has revised its original proposal that investment firms pursuing a market making strategy in at least one financial instrument during 30% of the daily trading hours during one trading day should sign a market making agreement with the trading venue. In the final draft RTS the threshold has been changed to 50%. Investment firms will be obliged to enter into a market making agreement when posting firm, simultaneous two-way quotes of comparable size and at competitive prices in at least one financial instrument on a single trading venue for at least 50% of the daily trading hours of continuous trading at the relevant trading venue, excluding opening and closing auctions, and for half of the trading days over a one month period.
ESMA has also stated that in its view the market making agreement should be limited to those instruments in which the investment firm is pursuing a market making strategy. It also acknowledges that there is nothing to prevent a trading venue and investment firm covering more than one financial instrument under the same agreement.
Article 2 of MiFID II provides for a narrower interpretation of exempt activities thereby capturing within its scope a range of firms previously excluded. The existing exemptions for commodity firms under articles 2(1)(i) and 2(1)(k) of MiFID are carried over in similar but not identical terms into article 2(1)(j) of MiFID II with the exemption in article 2(1)(k) of MiFID ceasing to exist.
Article 2(1)(j) provides that MiFID II will not apply to persons:
In both cases the exemption is subject to the condition that the activity is an ancillary activity individually and on an aggregate basis to the person’s main business, when considered on a group basis, and that the main business is not the provision of investment services within the meaning of MiFID II or banking activities under the Capital Requirements Directive IV (CRD IV), or acting as a market maker in relation to commodity derivatives, and the persons do not apply a high frequency algorithmic trading technique.
Article 2(4) of MiFID II requires ESMA to develop draft RTS to specify the criteria for establishing when an activity is to be considered as ancillary to the main business on a group level.
In its consultation paper ESMA proposed two tests that need to be passed cumulatively in order for investment activities to be considered as ancillary. The first test covers trading activity thresholds, with the second test covering main business thresholds. The trading activity thresholds test compares the size of the firm’s trading activity to the size of the overall market trading activity in the EU (i.e. determining the market share of a given entity in a commodities derivatives class). In the final report ESMA considers that there is merit in applying the trading activity test at an asset class specific level. A higher threshold for the C10 asset class has been set at 15% with an even higher threshold of 20% set for emission allowances. The other thresholds are:
ESMA has also noted that for the trading activity threshold, only activity undertaken for non-hedging purposes has to be taken into account.
In relation to the main business threshold test ESMA consulted on a proposal that was based on considering the ratio of the capital employed for carrying out the ancillary activity to the capital employed for carrying on the main business. In the final report ESMA states that it has reviewed and “fundamentally changed” the approach in relation to the calculation, abandoning the capital employed test and taking into account the overall activity of a group’s main business without any further reductions (encompassing privileged transactions and transactions executed in an entity of the group authorised in accordance with MiFID II or the CRD IV).
ESMA also clarifies that the comparison of the ancillary activity against the main activity should be done by comparing all ancillary activities taken together against the main activity. Where a firm undertakes only one of the ancillary activities mentioned in article 2(1)(j) (dealing on own account or providing investment services) it would only have to undertake the ancillary test on the basis of this individual ancillary activity.
In its consultation paper ESMA proposed that a single draft RTS would cover: (i) non-discriminatory access to and licensing of benchmarks; and (ii) non-discriminatory access to CCPs and trading venues. However, to provide further clarity, there are now two separate final draft RTS, one for each of those subjects.
The main principles on benchmark information have been retained in the final draft RTS although to ensure legal certainty some changes have been made to the drafting. In particular, ESMA states that it has aligned as far as possible the text on the information about methodology with a similar provision in the draft Regulation on indices used as benchmarks.
In relation to the RTS that have been developed under article 37 of MiFIR concerning how a benchmark may be proven to be new, the drafting of the RTS is broadly the same as in the earlier ESMA consultation paper.
In the final report ESMA states that it received a large number of responses to its proposals in respect of its obligation to produce RTS under article 27(10) of MiFID II. This article is in regard to information relating to best execution and covers: (i) the specific content, the format and the periodicity of data relating to the quality of execution to be published, taking into account the type of execution venue and the type of financial instrument concerned; and (ii) the content and the format of information to be published by investment firms.
In relation to point (i) ESMA notes that one of the main issues raised by stakeholders was the extension of the scope of the proposals to market makers and other liquidity providers for financial instruments subject to the trading obligation set out in MiFIR. Responding to these concerns ESMA has now amended the RTS to ensure that only trading venues and systematic internalisers are subject to publishing data for financial instruments subject to the trading obligation.
ESMA also acknowledges concerns that relate to the publication of data on illiquid instruments that are rarely traded. To address these concerns ESMA has clarified that where no transactions occur in a particular financial instrument on a particular day, an execution venue is not required to publish the reports dealing with price information. ESMA expects this to materially reduce the volume of reporting.
ESMA has also altered the RTS so that execution venues that operate a number of different markets do not provide a single report but rather provide information for each segment they operate. ESMA gives the example in the final report of where an established regulated market has a main order book and a separate order book for equities of smaller or growing companies. ESMA states that in such circumstances it considers that the venue should provide the information as set out in the RTS for each order book in order to ensure that the public has information on the quality of execution on all markets.
In relation to point (ii) ESMA notes that a large number of respondents were concerned about the publication of commercially sensitive information. To protect sensitive information it has provided in the final draft RTS that the number and volume of client orders executed on each of the top five venues are provided as a percentage of the firm’s total for that class of financial instruments. ESMA has also significantly reduced the number of classes of financial instruments whilst believing that it has retained sufficient granularity to ensure a meaningful response.
ESMA has also maintained the definition of execution venues that was contained in its consultation paper. Some respondents had issues with the inclusion of market makers and systematic internalisers among the top 5 venues. However, ESMA was of the view that the inclusion of execution venues in article 27(6) of MiFID II requires information on order flow beyond trading venues.
Whilst welcoming ESMA’s simplification of the reporting requirements for best execution, the Investment Association has argued that it remains the case that the level and complexity of data to be received by the investment industry’s clients will not assist them in getting a better understanding of how their assets are being managed.
ESMA has now sent the technical standards to the European Commission.
On receiving the draft RTS, the Commission will have forwarded them to the European Parliament (EP) and the Council of the EU (the Council). Within three months of receiving the draft RTS, the Commission must decide whether or not to endorse the RTS by adopting them. Only in “very restricted and extraordinary circumstances” should the Commission exercise its power to amend the RTS and this should only be done with prior co-ordination from ESMA. As soon as the Commission adopts the RTS it must notify the EP and the Council. If the Commission adopts the RTS that are the same as the draft RTS submitted by ESMA, the EP and the Council have one month to object to them from the date of being notified by the Commission that it has adopted the RTS. The EP or the Council may extend this deadline by a further month. If the Commission has adopted RTS that are not the same as the draft RTS submitted by ESMA, the EP and Council have three months to object to the RTS. This deadline may also be extended by a further three months on request by the EP or Council. If no objection is forthcoming from either the EP or the Council during the relevant time period the RTS will be published in the Official Journal of the EU (OJ) as Delegated Regulations.
Like the RTS, ESMA has now submitted the ITS to the Commission which has forwarded them to both the EP and the Council. Again, the Commission has three months in which to decide whether or not to endorse the ITS by adopting it. This period may be extended by another month. Unlike RTS the EP and the Council have no power of veto over ITS. Following adoption by the Commission, the ITS will be published in the OJ.
Implications for cryptocurrency trading, smart contracts and AI
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