There is the widespread assumption that MiFID II/R will lead to increased levels of pre-trade transparency and significantly reduce OTC trading, restricting it to the less liquid and more bespoke products.

This assumption is driven in large part by the joint introduction of obligatory Market Making agreements, a stricter interpretation of Systematic Internalisation and the introduction of the Trading Obligation for Investment Firms.

However, there is a high possibility that the market is overestimating the effectiveness of these measures for a number of reasons that I will discuss, key amongst which is the definition (or lack of it) of “OTC” in MiFID II/R.

In the interest of brevity, this discussion will be based in the context of non-derivative instruments; I will address derivative instruments separately given their intricacies (OTFS, clearing obligation, etc.).

Market Making Agreements and central limit orderbooks

Regarding the introduction of mandatory Market Making agreements, the obligation relates to firms whose model is to provide liquidity in central limit order books, and the effectiveness of this measure may be impacted by the following:

First, the definition of what constitutes market making activity, how much of an algorithmic trading firm’s flow meets this definition, and the degree to which this technicality can be used by firms wanting to avoid any contractual Market Making obligation.

Second, the provisions are generic enough to allow trading venues to avoid any requirement that could be too onerous on liquidity providers and potentially detrimental to their mutual commercial interests.

Third, the possibility of offering higher incentives in ‘stressed’ market conditions should raise a few questions. Algorithmic trading strategies do not “fight” the market, they follow it. One ought to ask about the potential consequences of an incentive structure that may induce auto regressive behaviour under stressed conditions.

Independently of the above, a substantial part of overall liquidity provision is taking place under bilateral trading arrangements outside of central limit orderbooks, and is therefore inaccessible by the overall market. Neither the Stricter Definition of Systematic Internalisation or the Trading Obligation introduced in MiFID II/R are likely to make access to this liquidity any easier for the following reasons:

Systematic Internalisation

None of the requirements introduced for Systematic Internalisers are inherently different to the ones already in place for Equities under MiFID. The distinction between liquid and illiquid financial instruments, each with their own quoting requirements, will be extended to a wider scope of instruments, as will all other major requirements related to client order handling, price improvement, or the obligation to make quotes available in a manner that is easily accessible to other market participants on reasonable commercial terms.

Most importantly, the exemptions from publishing any quotes above relatively small sizes (Size Specific to Financial Instrument) regardless of the liquidity of the instrument, and the right to restrict access to liquidity, quotes or both based on commercial (but “non-discriminatory”) reasons, remain in place.

This means that firms operating under a SI regime will see little or no disruption to their business model as a consequence of which, and for all practical purposes, access to their prices and liquidity will remain mostly restricted to those firms with whom they have a bilateral relationship.

Trading Obligation

Finally, there is the assumption that the trading obligation for investment firms will be a key factor in forcing a significant shift away from OTC trading and into Trading Venues.

However, this assumption is valid only if your definition of “OTC” is the same as the MiFID definition of OTC, which is unlikely: neither MiFID nor MIFD II/R provide a definition of “OTC”, “OTC Trading”, “OTC Markets”, etc.

Rather, they follow a “definition by elimination” approach, and the consequences are pervasive as it significantly weakens the effectiveness of some of the key provisions in MiFID II.

By way of example, most Investment Firms whose business model consists in/includes the execution of client orders (retail or institutional) on own account, will be able to continue to do so independently of the characteristics of their activity (i.e. bilateral, organised, frequent, systematic, substantial). In most cases it will be up to the Investment Firm to decide whether those transactions fall under a Regulated Market regime or a Systematic Internaliser regime. In either case, this liquidity will remain off limits to the market as a whole.

I do not know whether any of the above points may have come as a surprise to many readers, but if it has, it may be an indication that the market is overestimating the impact of some of the key provisions within MiFID II, especially regarding pre-trade transparency, price formation and liquidity.

We may be in for a surprise.

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