Regulating Fixed-Income Platforms: Separating Fact from Fiction

The fixed-income trading space has exploded with innovation from electronic trading protocols to new pricing services. In recent years, execution management systems (EMSs) have expanded their functionality in fixed income to provide more efficiency and price transparency to the buy side. Now a global conversation is taking place about the regulation of fixed-income electronic trading platforms, and this could have huge implications for innovation in the fintech space.

Both the European Securities Markets Authority (ESMA) and the Securities and Exchange Commission (SEC) are examining fixed income trading and whether changes are necessary to the existing regulations under MiFID II and Regulation ATS. Specifically, ESMA issued a consultation paper in Sept. 25, 2020, examining the organized trading facility (OTF) landscape for bonds and derivatives, responding to concerns that firms were operating systems functioning in a similar manner to multilateral trading facilities (MTFs) without being authorized as a trading venue. In its final report on the functioning of OTFs under MiFID/MiFIR, issued on March 23, ESMA summarizes the outcome of its consultation paper, and offers recommendations on the definition of an OTF and MTF, and offers its analysis on extending the regulatory perimeter of trading venues to ensure a level playing field.

Around the same time, the SEC issued a proposed rule change on Sept. 28, 2020 to Regulation ATS, around enhancing the regulatory oversight for ATSs that trade government securities and repurchase or reverse repurchase agreements.  In addition, the SEC issued a concept release seeking public comment on the regulatory framework for electronic platforms that trade corporate debt and municipal debt.

ESMA and the SEC are correct in conducting a review to ensure that they are not missing anything and are collecting all information about bond trading occurring through trading systems. However, it is important to distinguish between different types of trading systems and software providers before arriving at a conclusion that could have unintended consequences.

The regulatory debate has already begun to put a chill on innovation that is designed to bring efficiency to the market. In April, Waters Technology reported that communications and workflow platform provider Symphony has suspended its Sparc offering indefinitely as it engages with the US Commodity Futures Trading Commission on whether the service needs to register as swap execution facility or SEF.  Sparc allows buy-and-sell-side traders to use a single chatroom for both request-for-quote (RFQ) negotiations and standard messages.

Clarifying what an EMS does

Fintech providers like FlexTrade exist to make fixed-income trading more efficient and improve market transparency.  In our case, the EMS allows the buy side to create a bilateral connection with a bank or dealer. By using the request-for-quote trading (RFQ) protocol, the buy side can ask for and receive back prices from one or more dealers and display those prices on the EMS blotter.

The visual representation of data on a screen may resemble a trading venue.  However, not every software provider that displays bids and offers on a screen is functioning as a trading venue. The view that “if it looks like a duck and quacks like a duck, then it must be a duck,” is not based on the underlying facts. “Just because a screen looks like an MTF, because it has a stack of quotes on the screen, doesn’t mean it’s an MTF,” said Andrew Mahoney, Managing Director at FlexTrade EMEA.

According to Mahoney, this is no different than using an Excel spreadsheet to hook up to bank direct feeds. But that does not make Microsoft an MTF operator. It purely means that one person or entity is connecting to multiple streams of liquidity and presenting them in a format that allows a user to compare various instruments.

However, in Section 4.23 of ESMA’s final paper on OTFs, the regulator extends the requirement to register as an authorized trading venue to a broader set of trading systems that allow for information exchange of the financial terms – without any transaction occurring.

“…ESMA considers any system that allows third party trading interests in financial instruments to interact, including information exchange on essential terms of a transaction (being price, quantity) with a view to dealing in those financial instruments is sufficient to require authorisation as a trading venue. The information exchanged does not need to lead to a contractual agreement within the system between parties for the interaction to occur.”

Defining MTFs & OTFs

This raises questions about what constitutes an MTF or an OTF. To get at the heart of the matter, the industry should go back to the definition of an MTF or OTF as defined by each regulation.

Under MiFID II, there is an obligation to operate under a trading venue authorization, either as a regulated market (i.e., an exchange), MTF or OTF if the trading vehicle operates as a multilateral system. However, the obligation to operate as an authorized trading venue hinges on the definition of multilateral trading system.

As stated by ESMA’s consultation paper:

The definition is specified in Article 4(10) of MiFID II: a multilateral system “means any system or facility in which multiple third-party buying and selling trading interests in financial instruments are able to interact in the system.”

The SEC’s concept release about the regulatory framework for electronic corporate bond and municipal securities cites the following definition: “Exchange Act Rule 3b-16 (a) sets forth a functional test of whether a system meets the definition of an exchange. (1) Brings together the orders for securities of multiple buyers and sellers; and (2) uses established, non-discretionary methods (whether by providing a trading facility or by setting rules) which such orders interact with each other and the buyers and sellers entering the orders agree to the terms of a trade.”

Responding to the SEC’s concept release, FlexTrade’s President & CEO Vijay Kedia submitted a comment letter addressing the definition of an exchange or ATS.

In our case, (1) The EMS offered by FlexTrade does not bring together the orders for securities of multiple buyers and sellers. (2) The EMS provides a front-end for the user to enter orders. However, such orders do not interact with any other FlexTrade client’s orders and are only visible to the venue or broker to whom these orders are sent.

To shed further light on the issue, FlexTrade provided a ‘litmus test’ to assist the Commission determining whether a fixed-income trading platform for corporate and municipal bonds meets the criteria that warrants registration as an exchange or ATS. (Click here to read FlexTrade’s comment letter).

“We believe that software vendors that provide functionality for displaying prices and routing orders to fixed-income trading platforms do not meet the definition of an exchange and should not be required to register as an ATS,” stated Kedia in the comment letter.

“It is our belief that a software-only provider is not acting in the capacity of an exchange, or ATS,” Kedia further stated.

Understanding Software Nuances

Regulators should be aware of the distinction between a software-only provider as compared to a software-service model from an architectural standpoint.

FlexTrade emphasized the distinction in a comment letter to ESMA’s consultation: “Software only providers” sell software (e.g., compiled code) which clients can install on their own infrastructure, to connect bilaterally to counterparties of their choosing.  Each client has their own independent instance of the software, configured with only their own counterparties.”

FlexTrade is operating as a software-only provider so there is no shared back-end infrastructure, pointed out Mahoney.

“In FlexTrade’s case, our architecture and the instance of our infrastructure is unique, such that there can only be one buyer interacting with multiple sellers in an instance of the FlexTRADER EMS,” said Mahoney.

Hence, the EMS operated by FlexTrade does not allow for multiple buyers and sellers to interact.  “It’s a purely bilateral conversation,” said Mahoney. This is a unique feature of our architecture, said Mahoney. Each buy-side firm has its own instance of the system. This differs from an MTF whereby multiple buyers and multiple sellers can interact, he said.

“In fact, we have a few clients where we have no access to their back end, no access to any of their infrastructure, no access to their logs, yet they are still running FlexTRADER EMS. The only time we have access is if they have a technical issue, and usually that is the day after it happens. How can that be considered an MTF?” said Mahoney.

However, there are EMSs that operate as a software service (or software-as-a-service known as SaaS) where clients login to a shared infrastructure and shared back-end, noted FlexTRADE in its comment letter to ESMA.

“Software service providers” provide a portal for clients which allows them to connect, through a shared infrastructure across all clients, to counterparties where the client has a relationship.  The shared infrastructure is managed and monitored by the software service provider.  Clients can view quotes from multiple counterparties and interact with the available liquidity in various ways (e.g., user interface, or API).

There is a potential grey area when multiple buyers and multiple sellers have a shared back end, suggested Mahoney. “If one client pumps a lot of RFQs into the shared back end, this could influence the other party’s decisions,” he said.  It really depends on the definition of “interaction”, either in a trading sense, or a technical one. But in the final consultation paper, ESMA is recommending that “distributed trading systems, i.e., software not operated centrally but licensed to individual clients, allowing them to interact for trading purposes on a “point-to-point” basis, can constitute multilateral systems.” While stating that cases need to be analyzed carefully in terms of the exact operation of the software, ESMA wrote, it cannot be concluded that those systems are allowing by design only “multiple bilateral interactions” (as opposed to the simultaneous interactions of multiple trading interests.

According to FlexTrade, regulators should look at the characteristics of the software-only provider and the software provider, while formulating their definition of what an MTF or OTF is.

 “ESMA should explicitly define ‘software-only providers’ as out of scope, since there is no ability for them to become a trading venue, since they have no visibility into what clients are doing, and play no role in the trade,” wrote FlexTrade in response to Esma’s consultation.

Risk of Stifling Innovation

EMSs exist to make fixed-income trading more efficient for the buy side, establish bilateral connections with bank liquidity providers, and improve price transparency. This includes capturing and mapping the details of a voice trade so it can be booked electronically in an EMS.  “Traders are trying to electronically record and route their orders to make them less error prone, more robust, and more integrated with the existing landscape of liquidity providers,” said Mahoney. This will give regulators such as ESMA and the SEC an audit trail with more visibility into fixed income transactions, said Mahoney.

ESMA acknowledges that OMS and EMS providers allow trading firms to manage their orders more efficiently with “evident benefit in terms of costs, access to markets and latency of execution.”  However, ESMA cites concerns that those systems can be operated in a way which is similar to trading systems operated by trading venues. ESMA indicates that it’s important to look more closely at order and execution management systems to define “more precisely their regulatory boundary and what should differentiate them from trading venues.”

However, if technology providers are required to register as authorized trading venues and be subject to MTF/OTF or ATS compliance rules, this will impose burdens on independent fintech providers and potentially stifle innovation.  The burden of an MTF/OTF is not insignificant.  Ultimately, this could hurt institutional investors who are relying on EMSs to access liquidity and price transparency.