In its submission to the European Commission, the pan-European bourse backs plans for revising the EU Investment Services Directive to adopt a more flexible framework which ensures that different types of venue are accommodated, while maintaining overall market quality and investor protection.
Euronext's Chief Executive Officer and Chairman of its Managing Board, Jean-Francois Theodore, said the submission reflected Euronext's view that: "Competition is the best way to build an efficient European capital market, with competition not only between regulated markets, but also including electronic communications networks or alternative trading systems of all kinds". He said that the challenge for regulators would be to enable choice and innovation - including, for example, "internalisation" of securities trading within major investment banks - while ensuring that retail investors, in particular, were appropriately protected, wherever they traded.
Euronext believes that the revised framework should "aim to ensure fair and effective competition between the different types of venue, to guarantee transparency in price formation throughout these markets, and to protect the market user". The goal is "competition and innovation, but not at the expense of overall market quality or investor protection".
In developing detailed regulations, Euronext urges careful consideration of market-wide issues relating to price formation, price transparency, best execution, conflicts of interest and investor consent. This will ensure that there is genuine competition and that the investor
Revision of the Investment Services Directive
Euronext's proposals for the ISD in relation to the EU's cash equity markets
Background
Euronext was formed by the merger of the Amsterdam, Brussels and Paris cash and derivatives exchanges in September 2000. The company has since grown further, adding BVLP, the Portuguese cash and derivatives exchange, and the London International Financial Futures and Options Exchange (LIFFE).
Euronext supports the objectives of the EU's financial services action plan (of which the revision of the ISD forms a key part). This comprises the drive towards a single European capital market and in particular the objective of an integrated European securities market by 2003.
It believes that these objectives are best secured by a balanced approach that protects the interests of investors, while retaining the flexibility that is necessary to allow for continuing innovation in fast-moving markets.
Euronext supports the Lamfalussy approach, whereby directives will establish the regulatory framework, with much of the detail being left to the Committee of European Securities Regulators (CESR) which, in turn, is committed to consulting market participants, including exchanges.
Euronext will be pleased to take part in that process from its unique perspective of operating cash and derivatives markets in five different EU jurisdictions.
From that perspective, Euronext is convinced that the directive should lay down general principles of investor protection, while recognising that how those principles are appropriately implemented in detail will depend upon the different characteristics of different marketplaces, e.g. retail or wholesale, cash or derivatives.
Against that background, this paper considers one emerging issue in relation to retail cash equity markets: namely, the challenges posed to regulators by the growth of internalised trading within large investment banks.
Competition & Innovation - Automated Trading Systems (ATSs) & Internalisers
As a commercial company, Euronext is committed to fulfilling the evolving needs of its customers. So far this has involved delivering cross-border trading through a single electronic trading system for cash equity products, and consolidating Europe's markets along horizontal lines - allowing customers choice at all stages of the trading process.
As a result, Euronext supports the European Commission's aim of increasing the efficiency of the European capital market and its proposal to allow a number of "order matching venues" for cash equity trading to co-exist. These comprise regulated markets, such as Euronext, ATSs, and internalised trading. The current ISD contemplates regulated markets but does not contemplate ATSs or internalised trading.
Whilst competition between these venues will ultimately create greater choice for investors, encourage innovation, and help develop overall market liquidity, Euronext believes this will only deliver benefit and provide proper investor protection if the revised ISD establishes an appropriate framework for these new venues.
By recognising these new order matching venues, the revised ISD can establish a framework within which CESR can determine appropriate detailed arrangements for trade transparency requirements. The framework should aim to ensure fair and effective competition between the different types of venue, to guarantee transparency in price formation throughout these markets, and to protect the market user. In this respect, Euronext considers that market users, and particularly retail investors, in all Member States will benefit from greater transparency in those equity transactions which are conducted outside traditional regulated markets.
A framework is needed because, in the past, each Member State had its own specific structure to protect investors. In some countries where the regulated market traditionally operated a central order book for cash equity trading, a "concentration" rule applied to bring all buying and selling orders to that order book, seeking to ensure efficient price discovery and price transparency for the benefit and protection of investors. In countries where the market was traditionally quote driven, or where trading was generally fragmented, requirements existed for the centralised reporting of transactions to the regulated market to facilitate price transparency and/or price linkages with the regulated market, once again for the benefit and protection of investors. In the UK, for example, the London Stock Exchange's SETS system introduced order driven trading alongside quote driven and block trading, but this non-order book business continues to be centrally reported and published. Also in the UK, the role performed by Retail Service Providers provides an example of a price linkage with the regulated market.
The revised ISD must establish a framework which requires that appropriate protections are implemented for the benefit of the investor across the different trading venues permitted. Euronext supports competition and innovation, but not at the expense of overall market quality or investor protection.
The traditional model where order flow is generally concentrated on regulated markets is already contemplated by the directive. This model delivers benefit in terms of price discovery, liquidity, best execution and therefore investor protection. Greater choice of venue needs to be accompanied by a new framework which guarantees continued price discovery and transparency. This means suitable conditions being developed for ATSs and internalisers.
For ATSs (i.e. multilateral order matching venues), Euronext believes that the new orientations of the Commission are appropriate since they recognise that, where an ATS is providing a service which is similar to the service provided by a regulated market, an ATS should abide by the same overarching principles.
The reformed ISD must also properly address the issue of internalisation of order flow. In the same way as the reformed ISD should set appropriate standards for regulated markets and for ATSs, the reformed ISD should similarly establish a suitable framework for addressing and governing the practice of internalising order flow. The objective is to assure that investors continue to derive benefit and protection in any and all execution venues.
The remainder of this paper concentrates on the practice of internalising order flow, examining the issues raised by this trend, and potential responses which may fall within the revised ISD framework or more detailed provisions to be agreed through CESR.
Internalisation - the Issues
There are several issues raised by internalisation of order flow by investment firms outside of the rules of a regulated market, which need to be addressed through the revised ISD to ensure free and fair competition between order matching venues, and to ensure that investors continue to be protected. Key amongst these are:
- Price formation and genuine competition
- For a central order book market, if firms are permitted to internalise order flow unconditionally, pre-trade transparency will be reduced and their clients' orders will no longer contribute to price discovery. Less pre and post trade transparency reduces investor protection. Moreover, market fragmentation further inhibits price discovery and investor protection if there is no transparency, or centralised reporting and publication, of trades being executed on alternative venues.
- If the investment firm internalising order flow has a monopoly on the execution of its client orders, and precludes other firms and investors from monitoring the price information arising from this process, not only will this process fail to contribute to price formation, but also the lack of transparency will inhibit competition. This is because the investor will not be able to compare execution venues to determine which is providing best execution, nor will he be able, in some cases, to access the best price.
- "Best execution"
- Permitting choice of venue means that a "best execution" rule is needed to govern the conduct of investment firms in directing investors' orders. Euronext considers that this best execution rule needs to be defined very carefully. Whilst price is generally agreed to be the central requirement of best execution, and whilst it is important for this to be made clear in any best execution rule, there are a number of complications, as follows:
- For an investment firm to satisfy a best execution rule which required it to obtain the best price for an order, it is first necessary for the prices available on all venues to be transparent. To achieve this, there must be an appropriate level of pre or post trade transparency for all venues, whether they be regulated markets, ATSs or investment firms internalising orders.
- For example, Euronext does not believe that a rule which uses the best bid or offer prices of the regulated market, as evidence of best execution for internalised transactions, to be sufficient. On the contrary, Euronext considers that a rule of this kind may fail to provide appropriate incentives for price competition or price improvement. Instead, prices in other venues artificially follow the regulated market price. This problem is exacerbated where bid and offer spreads on the regulated market have themselves widened, as a result of market fragmentation, since some order flow is no longer contributing to price discovery and liquidity within the regulated market.
- Euronext believes that it is necessary to develop a best execution rule which fosters price improvement and fair competition. Euronext also believes that this rule should recognise and reflect the comparative regulatory and structural safeguards offered to investors by a regulated market when compared with other venues.
- The best execution rule will need to be strictly enforced by the competent authorities in order to safeguard investors, particularly retail investors. In the absence of an appropriate best execution rule, or if the rule is not properly enforced, market fragmentation will have damaging long term effects, with a deterioration in the quality of bid and offer spreads on regulated markets, a price which will ultimately be paid by investors and by companies raising capital.
- Development of a suitable best execution rule will require careful debate within CESR.
- Conflicts of interest
- Acting as both broker and dealer, an investment firm who is internalising order flow needs to manage the resulting conflicts of interest carefully.
- Appropriate conditions need to be applied through the revised ISD to ensure that these conflicts of interest are managed appropriately. This should include appropriate warnings or disclosures being made to the investor and obtaining express consent from the investor before internalising his orders.
In establishing detailed arrangements to permit a broader choice of order-matching venues for retail cash equity trading, Euronext believes that, for reasons of investor protection, there should be a presumption that retail cash equity orders should be directed to a regulated market unless a specific alternative venue has been authorised by the investor, or a better price can be obtained elsewhere. In other words, a general presumption of best execution for transactions executed on a regulated market should be recognised.
- Different forms of internalisation
In practice, Euronext recognises that there are different forms of internalisation performed by investment firms. It may therefore be appropriate to implement more than one regime for internalisation, to reflect these different forms. For example:
- where an investment firm is operating a multilateral order matching system, then this activity should be subject to similar regulatory requirements as an ATS.
- where an investment firm itself (or its affiliate) acts as the principal, i.e. as buyer to its customers' selling orders, and seller to its customers' buying orders, Euronext recommends that the revised ISD should establish a framework for differentiating between "systematic" internalisation on the one hand and "incidental" internalisation on the other hand.
Euronext agrees that the ISD does need to be revised in order to ensure that the legislation keeps pace with innovations across Europe's capital markets. Euronext supports competition and supports innovation, as these deliver benefits for customers and for investors generally.
Euronext itself services a variety of markets and is continually evolving in order to meet the needs of its wide range of customers. In addition to providing efficient and effective central order book trading platforms for a wide range of products, Euronext continues to adapt to meet the needs of its customers. The Euronext.liffe derivatives market, for example, which has a significant proportion of professional investors, offers a range of wholesale trading facilities which operate alongside its central order book, to provide choice and flexibility; these enhancements meet the evolving needs of investors and should be viewed in the context of the symbiotic relationship required between Euronext.liffe contracts and related OTC and cash markets. In the field of equity trading, Euronext organises block trade facilities separate from the central order book, as well as order crossing facilities.
In the specific case of retail equity trading, Euronext believes that it is imperative for a regime permitting multiple order matching venues to be accompanied by a robust over-arching framework which assures fair and effective competition, fosters genuine choice and improvement, and protects the investor. The revised ISD should therefore establish a framework which addresses the different types of venue and promotes transparency in price formation throughout these markets.
For ATSs, and internalisation through multilateral order matching, this means subjecting them to the same over-arching principles that apply to regulated markets.
For internalisation where the firm (or its affiliate) is acting as principal, Euronext recommends the following overall framework:
- Where internalisation of order flow is conducted by an investment firm pursuant to the rules of a regulated market (e.g. with any trades being reported to, and published by, that regulated market), then this trading activity should not be subject to any further conditions or restrictions, assuming the rules are being complied with.
- Any other internalisation of order flow should be subjected to a specific regime, the framework for which is provided by the revised ISD. Euronext supports the view that this framework should differentiate between investment firms who are internalising orders as a principal on a systematic basis, on the one hand, and firms internalising orders on an incidental basis, on the other. This would allow detailed provisions for each type of internalisation, which are proportionate and appropriate in each case, to be agreed through CESR.
- Euronext considers that internalisation should be deemed systematic if it is carried out as a normal course of business of the investment firm.
- Euronext recommends that internalising orders on a systematic basis should become a specific core service for that investment firm, pursuant to the ISD.
- Euronext recommends the following detailed requirements for investment firms wishing to internalise orders on a systematic basis:
- appropriate public pre-trade and post-trade transparency
- publication of order handling rules (for example, execution priority rules) which must be non-discretionary
- prior general consent of the investor to execute his orders on an internalised basis
- post-trade, the investor should be informed of the venue of execution.
- Euronext suggests that internalisation should be deemed incidental where it is not part of the normal course of business of the investment firm.
- Euronext recommends that an investment firm wishing to internalise orders on an incidental basis should be required to meet the following requirements:
- appropriate post-trade transparency
- prior consent of the investor to execute his orders on an internalised basis
- post-trade, the investor should be informed of the venue of execution.
