3.01  The communiqué of the G20 finance ministers and central bank governors of 15 April 2011 states that participants in commodity derivatives markets should be subject to appropriate regulation and supervision and therefore certain exemptions from Directive 2004/39/EC are to be modified. These amendments affect in particular clearing houses, trade repositories, and trading venues and reflect the increased risk and technological development since the last financial crisis.

3.02  Like other types of derivatives, commodity derivatives can be traded both bilaterally between two counterparties that have negotiated the terms of a transaction between themselves or through an organized market place where potential buyers and sellers know they might find counterparties willing to trade with them and which facilitate the entry into of derivatives. Over the last few years, policy makers and regulators around the world have taken steps to encourage the trading of more derivatives onto organized market places that are regulated in some way. This started in the aftermath of the Financial Crisis of 2008, which highlighted shortcomings in the management of counterparty credit risk and an absence of sufficient transparency in over-the-counter (OTC) derivative markets. In order to improve resilience of OTC derivative markets going forward, at its meeting of 25 September 2009 the G20 called for the strengthening of OTC derivatives markets stating that ‘all standardized OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate and cleared through central counterparties by end 2012 at the latest’ and that OTC derivatives should be reported to trade repositories. It was also agreed to improve the regulation, functioning, and transparency of financial and commodity markets to address market manipulation and excessive price volatility. These commitments have led to various changes to requirements applicable to both market infrastructures such as exchanges and central counterparties and the financial and non-financial institutions that enter into commodity derivatives.

3.03  In Europe, these changes have been introduced through various pieces of legislative reform. One of the key pieces is MiFID II which both defines the types of commodity derivatives that are regulated and the types of activity undertaken in relation to them that requires authorization, it also defines the types of trading venues that create the European trading landscape. As of January 2018, there are three types of trading venue in Europe: regulated markets, multilateral trading facilities, and organized trading facilities, each of which is discussed in detail in (p. 111) this chapter. While there are some important distinctions between them, it will be noted that many of the same requirements apply to each of them. MiFID II also introduces the obligation that transactions between certain types of counterparties in certain types of derivatives must be concluded on a trading venue or a third country trading venue that has been deemed to be equivalent to a European trading venue for this purpose.¹ At the time of writing, no commodity derivatives have been mandated for the trading obligation or, indeed the clearing obligation under European Market Infrastructure Regulation (EMIR), which is a pre-requisite to a decision to mandate a type of derivative to the trading obligation in the absence of European Securities Market Authority (ESMA) exercising its own initiative power. To date, ESMA has decided not to mandate any commodity derivatives for the clearing obligation, but this may change in the future.

3.04  One of the benefits of having derivatives traded on trading venues is that the regulators can impose and enforce obligations on the users of those trading venues through the trading venues with a view to ensuring orderly trading. Some of the obligations in European and UK legislation are therefore applicable to operators of the trading venues, while others apply to those using their facilities and in many cases, these are mutually reinforcing. Requirements are designed to achieve a number of objectives such as ensuring that there is transparency to the market over price formation, minimizing volatility through limits on the size of positions that a person may hold in commodity derivatives and reporting of transactions executed to enable the regulators to monitor for market abuse.

3.05  Other pieces of legislation also require or encourage the trading of certain types of commodity derivatives on particular types of market, on which certain obligations are imposed. For example, the Regulation on Wholesale Market Integrity and Transparency (REMIT) creates the concept of organized market places for wholesale energy products and the EU ETS Auctioning Regulation creates the framework for auction platforms for emission allowances.

3.06  It should be noted that, while many of these obligations are inspired by international commitments, they are implemented in slightly different ways in different regions and countries within those regions. By way of example, we explain later how the UK regime for regulated markets differs from that set out in MiFID II. Equally, in an attempt to recognise the global nature of the commodity and commodity derivatives markets, some of the legislation incorporates provisions recognizing equivalent regimes in other regions. Again, the so-called ‘third country’ or ‘equivalence’ regime is an example of this. There is also recognition of the inter-connectedness of the spot and derivatives markets in commodities. This is particularly relevant in the context of market abuse and position limits.

3.07  In addition to the clearing obligation in relation to OTC derivatives, there is also an obligation in Markets for Financial Instruments Regulation (MiFIR) for derivatives concluded on regulated markets to be cleared through a central counterparty in MiFIR.² MiFIR also requires central counterparties, trading venues, and investment firms that act as clearing members to have in place effective systems, procedures, and arrangements to ensure that transactions in cleared derivatives are submitted and accepted for clearing as quickly as technologically practicable using automated systems.³ This is known as the straight-through processing requirement and the precise obligations on each party and the timeframes within which they must perform them are set out in a technical standard.⁴ Cleared derivatives for these purposes means all of those that are subject to the clearing obligation in MiFIR described earlier, those that are subject to the clearing obligation in EMIR and those that the parties otherwise agree to clear.

3.08  Indirect clearing arrangements are only permissible in relation to exchange traded derivatives if they do not increase counterparty risk and ensure that the assets and positions of the counterparty benefit from protection with equivalent effect to that provided for under EMIR. Indirect clearing arrangements are the set of contractual relationships between providers and recipients of indirect clearing services provided by a client of a clearing member, its client (an indirect client), or a client of the indirect client (a second indirect client).⁵ It should be noted that exchange traded derivative is defined to include any derivative that is traded on a regulated market or a third country market considered to be equivalent to a regulated market pursuant to the trading obligation in MiFIR, and as such is not an OTC derivative under EMIR.⁶ The EU Commission has set out the standards that must be met by each of the central counterparty, clearing member, and client providing indirect clearing in a technical standard.⁷ A client can only provide indirect clearing if it is an authorized credit institution or investment firm or an entity established in a third country that would be considered to be a credit institution or investment firm if that entity were established in the EU and its clearing member agrees to its terms and conditions for indirect clearing. A clearing member and client that provide indirect clearing (p. 113) services must offer at least two specified types of account between which the indirect client can choose: (a) an omnibus account with the assets and positions held by the client for the account of all of its indirect clients; and (b) an omnibus account with the assets and positions held by that client for the account of its indirect clients, in which the clearing member must ensure that the positions of one indirect client do not offset the positions of another indirect client and that the assets of an indirect client cannot be used to cover the positions of another indirect client. The second option requires the central counterparty to keep records of each indirect client’s positions and assets and to calculate and collect margins relating to each indirect client on a gross basis. The requirements are not simple to comply with, not least because the clearing member must establish procedures to deal with the default of an indirect client and the clearing member must establish procedures to deal with the default of the client. In relation to the second type of account, the clearing member must also commit to the transfer of the assets and positions held by a defaulting client for the account of its indirect clients to another client or clearing member that has been designated by the relevant indirect clients, without obtaining the consent of the defaulting client. In the event that this is not possible within a specified timeframe, the clearing member must be able to liquidate the assets and positions of the defaulting client and pay the liquidation proceeds to each of the indirect clients or, where the clearing member has not been able to identify the indirect clients, to the client for the account of the indirect clients. There are additional requirements for indirect clients and second indirect clients providing clearing services to their respective clients.

3.09  There are a number of different reporting regimes that are relevant to European trading venues. Each of them is different in terms of its detail because each has been designed for a different purpose. In some cases the obligation applies to the trading venue and in others to the user of the trading venue.

3.10  There are a number of reporting obligations in MiFID II and MiFIR alone. The first is known as transaction reporting and is intended to enable the competent authorities to detect market abuse and facilitate its enforcement by virtue of the details of transactions executed being reported to them. The obligation applies primarily to investment firms that execute transactions in financial instruments that are traded on a trading venue or whose underlying is a financial instrument traded on a trading venue or whose underlying is an index or basked composed of financial instruments traded on a trading venue, and applies even if the derivative is executed outside a trading venue. However, the operator of a trading venue must report details of transactions that are executed through its system by firms which are not subject to MiFIR, such as unauthorized end users. Reports can be made by an investment firm itself or through an approved reporting mechanism (ARM) acting on its behalf or the trading venue through (p. 114) whose system the transaction was concluded.⁸ The second form of reporting is post-trade transparency, which is rather the publication of information about transactions in derivatives and other financial instruments traded on a trading venue. This applies to both trading venues and investment firms that execute transactions in such derivatives outside a trading venue and is explained in further detail later in this chapter.⁹ The third is position reporting which applies to both trading venues and investment firms that trade commodity derivatives, emission allowances, or derivatives on emission allowances. Its purpose is to enable both trading venues and competent authorities to manage and enforce position limits. Investment firms are required to report information about their own positions and those of their clients to the relevant trading venue and trading venues are required to report the details to the competent authorities on a daily basis and publish a summary to the market weekly.¹⁰ Finally, regulated markets and investment firms that are systematic internalisers are required to report reference data about financial instruments traded on their systems to their competent authorities in order to enable ESMA to publish such reference data so that investment firms can use it to complete their reports.¹¹

3.11  The reporting obligations do not apply to trading venues specifically but they require both financial and non-financial counterparties to derivatives traded on trading venues (as well as those traded otherwise) to report them to a trade repository that is registered with EMIR.¹² The information that needs to be reported for these purposes overlaps with that required for transaction reporting under MiFIR. It is therefore possible to satisfy both requirements by reporting all the information needed for both purposes to a trade repository which is also an Approved Reporting Mechanism (ARM).¹³

3.12  Finally, market participants are required to report details of transactions and orders to trade in wholesale energy products to a registered reporting mechanism for the purpose of monitoring and detecting market abuse in wholesale energy markets. In practice, where transactions and orders take place on an OMP, the OMP will facilitate reporting on behalf of the market participants.

3.13  A regulated market is a multilateral system operated and/or managed by a market operator, which brings together or facilitates the bringing together of multiple third party (p. 115) buying and selling interests in financial instruments—in the system and in accordance with its non-discretionary rules—in a way that results in a contract, in respect of the financial instruments admitted to trading under its rules and/or systems, and which is authorized and functions regularly and in accordance with Title III of MiFID II.

3.14  Member States can only authorize a regulated market where the competent authority is satisfied that both the market operator and the systems of the regulated market comply with these requirements. Given that these requirements are set out in a directive, Member States need to implement them into their own domestic legislation and it is therefore important to refer to this to understand the exact requirements. This section, however, describes the requirements as set out in MiFID II.

3.15  A market operator is a person who manages and/or operates the business of a regulated market and may be (and often is) the regulated market itself. Where the market operator and the regulated market are different legal persons, the relevant Member State determines how the obligations apply to each of them. Although a market operator is not authorized to provide other investment services, it can also operate a Multilateral Trading Facility (MTF) and/or an Organized Trading Facility (OTF), provided it complies with the rules applicable to them.

3.16  In order to become authorized as a regulated market, the market operator must provide to the competent authority the information necessary to demonstrate that it will be able to satisfy all the requirements at the time of its initial authorization. This will include a programme of operations setting out the types of business the regulated market will undertake and its organizational structure. Different Member States may have specific processes and forms for such applications.

3.17  Once authorized, the regulated market must continue to comply with the requirements and the relevant competent authority will supervise it for this purpose. The competent authority can withdraw authorization in certain circumstances including where the regulated market no longer meets the conditions under which it was granted authorization.¹⁴

3.18  ESMA maintains a list of regulated markets on its website, including their market identifier codes, which are needed for post-trade transparency and transaction reporting.

3.19  As would be expected, there are detailed requirements for the management body of a market operator.¹⁵ This is the body which is appointed in accordance with national law, (p. 116) to set the entity’s strategy, objectives, and overall direction, and to oversee and monitor management decision-making and effectively direct the business of the entity.

3.20  All members of the management body must at all times be of sufficient good repute and possess sufficient knowledge, skills and experience to perform their duties. ESMA Guidelines¹⁶ permit market operators to take into consideration both theoretical knowledge and skills attained through education and training as well as practical experience gained in previous occupations and suggest that consideration should also be given to the practical experience gained from a managerial position over a sufficiently long period.

3.21  They must also act with honesty, integrity, and independence of mind to effectively assess and challenge the decisions of the senior management where necessary and to effectively oversee and monitor decision-making. The ESMA Guidelines provide a list of criteria against which honesty and integrity should be assessed, as well as examples of the types of conflicts of interest to which management bodies should have regard.

3.22  The management body must commit sufficient time to perform their functions and for this reason there is a limit on the number of directorships they can hold taking into account individual circumstances and the nature, scale, and complexity of the market operator’s activities. The ESMA Guidelines provide additional information on calculating the number of directorships held and suggest that firms should provide information about their other directorships and what they entail, as well as any changes that might impact on their ability to perform their role in relation to the regulated market. The Guidelines accept that the time required will depend on whether the director is an executive or non-executive but provide that they should confirm in writing that they can devote sufficient time to both their duties expected ordinarily and in times of increased activity.

3.23  Market operators must devote adequate human and financial resources to the induction and training of members of the management body. This is to facilitate the maintenance of members’ understanding of the market operator’s activities, structure, business model, risk profile, regulatory environment, and governance arrangements and the members’ roles in them.

3.24  The overall composition of the management body must reflect an adequately broad range of experience. The management body must possess adequate collective knowledge, skills, and experience to be able to understand the market operator’s activities, including the main risks.

(p. 117) 3.25  The role of the management body is to define and oversee the implementation of the governance arrangements that ensure effective and prudent management of an organization, including the segregation of duties and the prevention of conflicts of interest, and in a manner that promotes the integrity of the market. The management body should periodically assess the effectiveness of such arrangements and take appropriate steps to address any deficiencies.

3.26  Members of the management body must have adequate access to information and documents which are needed to oversee and monitor management decision-making.

3.27  The competent authority must refuse authorization if it is not satisfied that the members of the management body satisfy these criteria, or if there are objective and demonstrable grounds for believing that the management body may pose a threat to the effective, sound, and prudent management and integrity of the regulated market. For this reason, a market operator must notify the competent authority of the identity of all members of its management body and of any changes, along with all information needed to assess whether the market operator complies with these obligations.

3.28  A market operator that is significant in terms of size, internal organization, and the nature, scope, and complexity of its activities should establish a nomination committee composed of members of the management body who do not perform any executive function in the market operator. The purpose of the nomination committee is to:

• •  identify and recommend candidates to fill management body vacancies, evaluating the balance of knowledge, skills, diversity, and experience of the management body;

• •  assess the structure, size, composition, and performance of the management body, and make recommendations with regard to any changes;

• •  assess the knowledge, skills, and experience of members of the management body and of the management body collectively, and report to the management body accordingly; and

• •  periodically review the policy for selection and appointment of senior management and make recommendations.

3.29  In performing its duties, the nomination committee shall take account of the need to ensure that the management body’s decision-making is not dominated by any one individual or small group of individuals in a manner that is detrimental to the interests of the market operator. Nomination committees should engage a broad set of qualities and competences when recruiting members to the management body. In particular, the nomination committee is required to decide on a target for the representation of the underrepresented gender in the management body and prepare a policy on how to increase the number of the underrepresented gender in the management body in order to meet that target. The ESMA Guidelines also require that the recruitment and diversity policy should at least refer to educational and professional background, gender, age, and geographical provenance with the aim to achieve a variety of views and experiences, and provide for employee representation to add a different perspective and (p. 118) genuine knowledge and experience of the activities undertaken by the market operator. That said, market operators should not recruit members of the management body with the sole purpose of increasing diversity to the detriment of the functioning and suitability of the management body collectively, or at the expense of the suitability of individual members of the management body.

3.30  The requirements applicable to persons who own or otherwise control a regulated market in MiFID II are less prescriptive, although it should be expected that each Member State’s national competent authority will have designed a change in control process around them and may require additional information.¹⁷

3.31  The MiFID II requirement is that Member States must require the persons who are in a position to exercise, directly or indirectly, significant influence over the management of the regulated market to be suitable. In order to do this, they must require the market operator of the regulated market:

• •  to provide the competent authority with, and to make public, information regarding the ownership of the regulated market and/or the market operator, and in particular, the identity and scale of interests of any parties in a position to exercise significant influence over the management; and

• •  to inform the competent authority of and to make public any transfer of ownership which gives rise to a change in the identity of the persons exercising significant influence over the operation of the regulated market.

3.32  The competent authority must refuse to approve proposed changes to the controlling interests of the regulated market and/or the market operator where there are objective and demonstrable grounds for believing that they would pose a threat to the sound and prudent management of the regulated market.

3.33  These requirements, as implemented into a Member State’s local requirements, are important to take into account when acquiring, increasing, decreasing, or disposing of an interest in a regulated market. The process can sometimes take time so needs to be factored into any project timetable.

3.34  Regulated markets are subject to a number of organizational requirements.¹⁸ In particular, a regulated market must:

• •  have arrangements to identify and manage the potential adverse consequences of any conflict of interest between the interest of the regulated market, its owners or its market operator and the sound functioning of the regulated market;

• (p. 119) •  be adequately equipped to manage the risks to which it is exposed, to implement appropriate arrangements and systems to identify all significant risks to its operation, and to put in place effective measures to mitigate those risks;

• •  have arrangements for the sound management of the technical operations of the system, including the establishment of effective contingency arrangements to cope with risks of systems disruptions;

• •  have transparent and non-discretionary rules and procedures that provide for fair and orderly trading and establish objective criteria for the efficient execution of orders;

• •  have effective arrangements to facilitate the efficient and timely finalization of the transactions executed under its systems; and

• •  have sufficient financial resources to facilitate its orderly functioning.

3.35  It is important to note that market operators are not permitted to execute client orders against proprietary capital, or engage in matched principal trading on any of the regulated markets they operate. They can never therefore become party to the derivative contracts that are formed through their systems and rather facilitate other persons entering into those derivatives.

3.36  Derivatives that are concluded on a regulated market must be cleared by a central counterparty and therefore members will usually enter into the market leg of a derivative contract with the central counterparty and, if there is a client leg, the client. Regulated markets must have arrangements to ensure that such derivatives are submitted and accepted for clearing as quickly as technologically practicable in accordance with CDR 2017/582. There are also requirements relating to indirect clearing.¹⁹

3.37  Regulated markets and their members and participants must synchronize their business clocks used to record the date and time of all reportable events in accordance with CDR 2017/574.²⁰

3.38  Regulated markets must have transparent and non-discriminatory rules based on objective criteria governing access to or membership of their regulated market. These rules are usually set out in a section of their rulebooks on eligibility criteria, which are published on their websites.²¹

(p. 120) 3.39  The rules must specify any obligations arising from the constitution and administration of the regulated market, the rules relating to transactions on the market, professional standards imposed on the staff of firms that are operating on the market, and the procedures for clearing and settlement of transactions.

3.40  MiFID II provides that regulated markets can accept as members or participants investment firms and credit institutions but also other persons who are of sufficiently good repute, have a sufficient level of trading ability, competence and experience, have adequate organizational arrangements, and have sufficient resources for the role they are to perform on the regulated market. It is therefore possible for a regulated market to accept members that are not authorized, provided that such members can demonstrate that they satisfy whatever additional criteria the regulated market might have imposed. That said, a regulated market may impose such additional criteria on firms and credit institutions as well. In addition, the market operator will want to know that an investment firm or credit institution is authorized to perform the relevant types of investment service to enter into transactions on the regulated market. What these are will depend on the way that contracts are formed on the regulated market and whether the member is entering into them in its own right or on behalf of a client.

3.41  Many persons who want to enter into a derivative that is traded on a regulated market will not be able to become a member and will therefore need to use another person that is a member. Most regulated markets permit their members to trade on behalf of others, although they may require them to satisfy additional criteria and treat them as a particular category of member. There is nothing in MiFID II to prevent regulated markets allowing their members to execute transactions as agent but, as a matter of practice, most European regulated markets in derivatives tend to operate on a principal to principal basis. This means that the rules of the regulated market require the member to enter into transactions as principal but the member can then enter into the same contract on the reverse terms with its client if it so wishes.

3.42  When investment firms and credit institutions trade on regulated markets, they do not need to comply with the investor protection rules under MiFID II in respect of other members and participants in the regulated market, but they do need to comply with those obligations towards their clients when they are acting on their behalf and executing their client orders. It should be noted that, under MiFID II, a client is any natural or legal person to whom an investment firm provides investment or ancillary services and makes no distinction between affiliates and external clients.²²

3.43  A regulated market must provide for both direct and remote membership or participation of investment firms and credit institutions and Member States must allow regulated markets from other Member States to provide arrangements to facilitate access to and trading on those markets by remote members and participants in their territory (p. 121) albeit that the regulated market must notify its competent authority, which must notify the competent authority of the other Member States of such an intention. This mechanism was traditionally needed to ensure that a regulated market in one Member State (e.g. the UK) can allow persons in another Member State (e.g. France) to trade on it in the days when the UK regulated market would have provided hardware such as screens to enable the French traders to access it. Now that there are other means to connect with an exchange in another country, this provision is essentially seen as a kind of passporting arrangement for regulated markets.

3.44  Regulated markets must tell their competent authorities the identities of their members and participants, and any ‘host’ Member State can also request such information. European regulated markets generally publish the identities of their members on their websites.

3.45  Regulated markets are required to have effective arrangements and procedures to monitor their members and participants’ compliance with their rules.²³ This includes monitoring orders and cancellations of orders sent and transactions executed for the purposes of identifying infringements of not only the rules, but also disorderly trading, market abuse, and systems disruptions. This is why regulated markets make clear in their rulebooks what types of behaviour are not permitted and reserve rights to require information from members and participants about the reasons behind their activities and to investigate behaviour about which they have concerns, sometimes suspending access to trading in the meantime.

3.46  Regulated markets are required to immediately inform their competent authorities of significant rule breaches and disorderly trading conditions that have the potential to jeopardize the role and function of the regulated market. CDR 2017/565 sets out some signals that may indicate such situations. Regulated markets usually make clear in their rulebooks that they have the right to make such reports.

3.47  Regulated markets must also inform competent authorities of conduct that may indicate market abuse and the same delegated regulation also sets out signals that may indicate this. However, regulated markets should apply a proportionate approach and exercise judgement on these and other potential signals, taking into account deviations from the usual pattern of trading on the regulated market and other information accessible to the operator, both internally (such as its order book data) and in the public domain. Regulated markets are subject to a similar detection and reporting obligation in the Market Abuse Directive and the two should be considered together. The regulated market must then provide full assistance to the relevant competent authority in the investigation and prosecution of such market abuse.

(p. 122) 3.48  The competent authority of the regulated market must notify information reported to it to ESMA and other relevant competent authorities.

3.49  Regulated markets must also have clear and transparent rules regarding the admission of financial instruments to trading, the purpose of which is to ensure that they are capable of being traded in a fair, orderly and efficient manner. In relation to commodity derivatives, they should in particular ensure that:²⁴

• •  the terms of the contract establishing the financial instrument are clear and unambiguous, and enable a correlation between the price of the derivative and the price or other value measure of the underlying commodity;

• •  the price or other value measure of the underlying commodity is reliable and publicly available, although this does not apply if (i) the contract is likely to provide a means of disclosing to the market, or enabling the market to assess, the price or other value measure of the underlying commodity, where the price or value measure is not otherwise publicly available; (ii) the regulated market ensures that appropriate supervisory arrangements are in place to monitor trading and settlement in such derivatives; and (iii) the regulated market ensures that settlement and delivery can be effected in accordance with the contract terms and conditions of those financial instruments;

• •  sufficient information of a kind needed to value the derivative is publicly available;

• •  the arrangements for determining the settlement price of the contract is such that the price properly reflects the price or other value measure of the underlying commodity; and

• •  where the settlement of the derivative requires or provides for the possibility of the delivery of an underlying commodity rather than cash settlement, there are adequate arrangements to enable market participants to obtain relevant information about that underlying commodity as well as adequate settlement and delivery procedures for the underlying commodity.²⁵

3.50  Regulated markets must therefore consider carefully when they design new commodity derivatives how they can ensure that the contract can be priced in an orderly manner and settled effectively. Many regulated markets have a product committee whose function is to ensure that any new contract complies with all applicable requirements and that they can demonstrate this to their competent authority, which may require to be (p. 123) notified of any new products, and that they are not launched until it is satisfied that they comply with these conditions. These committees may therefore be involved at all stages of the development of the contract and include representatives from many divisions such as Research and Development, Risk, Legal and Compliance, Market Surveillance, and Marketing. This is to ensure that it is considered from all relevant perspectives, including whether it satisfies the needs of members and participants; how it will be traded (such as through which matching algorithms or whether pre-negotiation might be permitted); how the price will be determined both normally and in the event that the normal mechanism is not available for some reason; whether there will be any limits on the amounts that can be traded; whether it will be settled physically or in cash; whether it poses any particular risks to orderly trading or could give rise to abuse of the derivative or the underlying spot commodity; how to document its terms and whether it requires any changes to be made to the rulebook; and how to explain it most clearly to the market.

3.51  Regulated markets must regularly review whether the instruments traded on their markets comply with the admission criteria described earlier.

3.52  As they are not investment firms, regulated markets are not subject to the product governance obligations in MiFID II. However, they are manufacturing derivatives and if investment firms and credit institutions that are subject to MiFID II distribute those derivatives to their clients, they will need information about the intended target market and distribution strategies.

3.53  A regulated market can suspend or remove from trading a commodity derivative that no longer complies with its rules, unless such suspension or removal would be likely to cause significant damage to the interests of investors or the orderly functioning of the market.²⁶

3.54  When a regulated market suspends or removes from trading any financial instrument, it must also suspend or remover any derivatives that relate or are referenced to it where necessary to support the objectives of suspending or removing from trading the original financial instrument and it must make these decisions public and communicate them to its competent authority.

3.55  Where the suspension or removal is due to suspected market abuse, a takeover bid or the non-disclosure of inside information in breach of Market Abuse Regulation (MAR), the competent authority of the home state of the regulated market must require other trading venues and systematic internalisers that trade the same financial (p. 124) instruments to also suspend or remove from trading both those instruments and any derivatives that relate to or are referenced to them, unless such suspension could cause significant damage. The competent authority must communicate its decisions to ESMA and the other competent authorities so that those competent authorities can tell other trading venues and systematic internalisers under their jurisdiction that trade the same financial instruments to do the same. This procedure is used in reverse where a suspension is lifted.

3.56  Competent authorities also have the powers to require the suspension of or removal from trading in a financial instrument in order to fulfil their duties under MiFID II and the same notification procedure is used also in that case.

3.57  Regulated markets are subject to very detailed and wide-ranging requirements around the types of systems and controls they must have in place. These requirements as presented later are set out in MiFID II itself, but they are further detailed in a series of technical standards which should also be consulted.²⁷

3.58  Regulated markets must have effective systems, procedures, and arrangements to ensure their trading systems are resilient, have sufficient capacity to deal with peak order and message volumes, and are able to ensure orderly trading under conditions of severe market stress. Their systems must also be fully tested to ensure such conditions are met and are subject to effective business continuity arrangements to ensure continuity of services if there is any failure of trading systems. These requirements are expanded in CDR 2017/584²⁸ for regulated markets that enable or allow algorithmic trading through their systems. Algorithmic trading means trading in financial instruments where a computer algorithm automatically determines individual parameters of orders such as whether to initiate the order, the timing, price, or quantity of the order or how to manage the order after its submission, with limited or no human intervention, and does not include any system that is only used for the purpose of routing orders to one or more trading venues or for the processing of orders involving no determination of any trading parameters or for the confirmation of orders or the post-trade processing of executed transactions.²⁹

3.59  They are required to enter into agreements with all investment firms pursuing a market making strategy on their markets. This applies where an investment firm, during half of the days over a one-month period, posts firm, simultaneous, two-way quotes of comparable size and competitive prices and deals on their own account in at least one financial instrument on at least one trading venue for at least 50 per cent of the daily trading (p. 125) hours of continuous trading at the respective trading venue, excluding opening and closing auctions. These agreements must set out the minimum obligations to be met by the investment firm in terms of posting quotes and monitoring and recording its market making activity. Regulated markets may also implement schemes to ensure that a sufficient number of firms participate in arrangements which require them to post firm quotes at competitive prices with the result of providing liquidity to the market on a regular and predictable basis. However, this is not required for commodity derivative markets.³⁰

3.60  Member States shall require a regulated market to have in place effective systems, procedures, and arrangements to reject orders that exceed pre-determined volume and price thresholds or are clearly erroneous. These should include at least limits on the number of orders any member may send per second, mechanisms to manage volatility and pre-trade controls. Pre-trade controls should include price collars, minimum order values, and maximum order volumes. Post-trade controls should be designed on the basis of the members’ activity. Trading venues are required to publish their policies and arrangements for these purposes.³¹

3.61  A regulated market must be able to temporarily halt or constrain trading if there is a significant price movement in a financial instrument on that market or a related market during a short period. They must also be able to cancel, vary, or correct any transaction in exceptional circumstances. Most markets do this using a mechanism known as circuit breakers. The parameters for halting trading should take into account the liquidity of different asset classes and sub-classes, the nature of the market model and types of users and be sufficient to avoid significant disruptions to orderly trading and various other factors described in ESMA Guidelines.³² Regulated markets must report the parameters for halting trading and any material changes to those parameters to the competent authority, which onward reports these to ESMA. Where a regulated market which is material in terms of liquidity in a financial instrument halts trading, ESMA will consider whether it is appropriate to coordinate a market-wide response and halt trading on other venues on which the financial instrument is traded.³³

3.62  Where a regulated market permits its members or participants to use algorithms, it must have in place effective systems, procedures, and arrangements to ensure that algorithmic trading systems cannot create or contribute to disorderly trading conditions (p. 126) on the market and to manage any disorderly trading conditions which do arise. They should require members or participants to test their algorithms and provide an environment in which they can do so. They must also have systems to limit the ratio of unexecuted orders to transactions that a member enters into the system, to be able to slow down the flow of orders if there is a risk of system capacity being reached and to limit and enforce the minimum tick size that may be executed on the market. A regulated market must be able to identify orders generated by algorithmic trading, the different algorithms used for the creation of orders and the relevant persons initiating those orders from different members.³⁴

3.63  A regulated market may only permit members to provide direct electronic access if they are investment firms or credit institutions that satisfy criteria it has set regarding the suitability of persons to whom such access may be provided. Direct electronic access is an arrangement where a member or participant or client of a trading venue permits a person to use its trading code so that person can electronically transmit orders to the trading venue.³⁵ The member retains responsibility for orders and trades executed using direct electronic access. The regulated market must set appropriate risk controls on direct electronic access trading and be able to distinguish and if necessary to stop orders by a person using direct electronic access separately from other orders by the member that granted such access. It must also have arrangements to suspend or terminate the provision of direct electronic access by a member or participant to a client in the case of non-compliance with its rules and conditions to providing direct electronic access, which it must publish.³⁶

3.64  Regulated markets that provide co-location services must ensure that their rules on this are transparent, fair, and non-discriminatory. Co-location services can take many forms, but are essentially designed to enable a member of the regulated market to locate servers close to those of the regulated market itself with a view to reducing latency in getting its orders into the matching engines of the regulated market.³⁷

3.65  Regulated markets must ensure that their fee structures including execution fees, ancillary fees, and any rebates are transparent, fair, and non-discriminatory³⁸ and that they do not create incentives to place, modify, or cancel orders or to execute transactions in (p. 127) a way which contributes to disorderly trading conditions or market abuse. They may charge higher fees for cancelled orders according to the length of time for which the order was maintained, for placing an order that is subsequently cancelled, for placing a high ratio of cancelled-to-executed orders and on those operating a high frequency algorithmic trading technique. Regulated markets must not offer their members or participants a ‘cliff-edge’ fee structure whereby, once their trades exceed a given threshold, all of their trades benefit from a lower fee for a set period, including those trades that were executed prior to reaching that threshold.³⁹

3.66  Regulated markets must give their competent authority access to, or data from, their order books on request so that it is able to monitor trading.

3.67  Regulated markets are subject to a number of reporting requirements. While the purpose of those regimes is to detect market abuse and manage volatility respectively, the purpose of the transparency regime is to enable firms to understand the demand and supply in the market and have visibility over price formation. The G20 committed to strengthening transparency in the aftermath of the Financial Crisis in 2009 and this led to an extension of the European transparency regime which at the time applied only to shares, to all other types of financial instruments, including derivatives, in MiFIR.

3.68  Regulated markets are subject to both pre- and post-trade transparency obligations. Pre-trade, regulated markets must make public current bid and offer prices and the depth of trading interest at those prices that are advertised through their systems. This applies to both orders and actionable indications of interest. However, they do not need to publish information about derivatives of non-financial counterparties which are objectively measurable as reducing risks directly relating to their commercial or treasury financing activity or that of their group.

3.69  Regulated markets must make this information available to the public on a continuous basis during normal trading hours. They must also give access on reasonable commercial terms and on a non-discriminatory basis to the arrangements they employ for making this information public to systematic internalisers, which are investment firms that are subject to an obligation to publish firm quotes.

3.70  The requirements are calibrated for different types of trading system so that the precise information to be published is tailored according to whether the regulated market is an order-book, quote driven, hybrid, periodic auction trading, or voice trading system.

(p. 128) 3.71  However, it is possible for a regulated market to apply for and be granted a waiver from the pre-trade transparency obligations in respect of the types of order described below:

• •  Large in scale: Orders that are large in scale compared to normal market size and orders held in an order management facility pending disclosure.

• •  Size specific to the instrument (SSTI): Actionable indications of interest in request for quote and voice trading systems that are above a size specific to the financial instrument, which would expose liquidity providers to undue risk. Where this waiver is used, the regulated market must still publish at least indicative pre-trade bid and offer prices which are close to the price of trading interests advertised through their systems.

• •  Illiquid: Derivatives that are not subject to the trading obligation and other derivatives for which there is not a liquid market.

• •  Exchange for physicals (EFPs): Orders for the purpose of executing an exchange for physical, being a transaction in a derivative or other financial instrument contingent on the simultaneous execution of a transaction in an equivalent quantity of an underlying physical asset.

• •  Packages: Package orders that meet certain conditions, a package order being a transaction which involves the execution of two or more component transactions in financial instruments; and

  • •  which is executed between two or more counterparties;

  • •  where each component of the transaction bears meaningful economic or financial risk related to all the other components; and

  • •  where the execution of each component is simultaneous and contingent upon the execution of all the other components. One of the conditions is that there is no liquid market for the package order as a whole, which must be determined in accordance with CDR 2017/2194.⁴⁰

3.72  CDR 2017/583⁴¹ sets out the detail on when the terms of these waivers might be satisfied, including the methodology for determining the normal market size and the size specific to a financial instrument for each class of commodity derivative.

3.73  A regulated market must apply for a waiver from its competent authority not less than four months before it wants to start using it. The competent authority must notify ESMA and other competent authorities of its proposed uses so that ESMA can opine on whether or not it is compatible with the requirements and maintain consistency in application across Member States. The competent authority that granted a waiver may (p. 129) also withdraw it, either on its own initiative or at the request of another competent authority if it considers that the waiver is being used in a way that deviates from its intended purpose or to circumvent the requirements.

3.74  The large in scale and exchange for physical waivers are used widely in the commodity derivatives markets. Many commodity derivatives can also benefit from the illiquid waiver at present. It can be difficult to know which, in any waivers, a regulated market has been granted because there is no central register. However, investment firms and credit institutions trading on a regulated market do need to know which waiver has been applied in order to be able to complete some of the fields in their transaction reports.

3.75  Regulated markets must also make public the price, volume, and time of each transaction executed as close to real time as technically possible and at least within fifteen minutes after the execution of the transaction until 1 January 2021, at which point it reduces to within five minutes after the execution of the transaction. Regulated markets can do this themselves or they can use an approved publication arrangement if they prefer. They must give access, on reasonable commercial terms and on a non-discriminatory basis, to the arrangements they employ for publication to investment firms and credit institutions that are also required to publish post-trade information.

3.76  However, it is possible for a trading venue to be permitted by its competent authority to defer publication until 19.00 local time on the second working day after the date of the transaction in relation to the types and sizes of transaction listed below:

• •  Large in scale: Those that are large in scale compared with the normal market size for that commodity derivative or for that class of commodity derivative.

• •  Illiquid: Those that are related to a commodity derivative traded on a trading venue, or a class of commodity derivative traded on a trading venue for which there is not a liquid market.

• •  SSTI: Those that are above a size specific to that commodity derivative traded on a trading venue, or that class of commodity derivative traded on a trading venue, which would expose liquidity providers to undue risk.⁴²

• •  Packages: Package transactions which meet one of the following criteria: (i) one or more of its components are transactions in financial instruments which do not have a liquid market; (ii) one or more of its components are transactions in financial instruments that are large in scale compared with the normal market size; and (iii) the transaction is executed between an investment firm dealing on own account other than on a matched principal basis and another counterparty, and one or more of its components are transactions in financial instruments that are above the size specific to the instrument.⁴³

(p. 130) 3.77  The regulated market should publish details of deferrals it has been granted but, again, there is no central register.

3.78  Deferrals are different in concept from waivers because, as the name suggests, deferrals are just that and the required information does have to be published after the deferral period. In addition, the competent authority can request a regulated market to publish limited details of transactions or information in an aggregate form or a combination of these during the deferral period. Further, a competent authority can allow a regulated market not to publish the volume of individual transactions for an extended period of deferral in accordance with CDR 2017/583.

3.79  The competent authority responsible for supervising a regulated market may temporarily suspend the pre- and post- trade transparency obligations if liquidity of a class of commodity derivatives falls below a specified threshold.⁴⁴

3.80  For a class of commodity derivatives for which ESMA considers there to be a liquid market, this is where the total volume calculated for the previous thirty calendar days represents less than 40 per cent of the average monthly volume calculated for the twelve full calendar months preceding those thirty calendar days. For a class of commodity derivatives for which ESMA does not consider there to be a liquid market, this is where the total volume calculated for the previous thirty calendar days represents less than 20 per cent of the average monthly volume calculated for the twelve full calendar months preceding those thirty calendar days. The calculations take into account trading on all trading venues in that class of commodity derivatives in the EU.

3.81  A temporary suspension is valid for a up to three months from the date it is published on the website of the competent authority. It can be renewed for periods of up to three months at a time if the grounds for the suspension continue, but it automatically lapses if it is not renewed. Before suspending or renewing a suspension, the competent authority must notify ESMA of its intention and the reasons behind it, and ESMA will issue an opinion on whether the proposed suspension or renewal is justified.

3.82  Regulated markets must make the information available to the public on a reasonable commercial basis. The price of market data should be based on the cost of producing and disseminating it and may include a reasonable margin. However, it must be made available free of charge fifteen minutes after publication. They must disclose the price and other terms and conditions for the provision of the market data in a manner which is easily accessible to the public.

(p. 131) 3.83  Regulated markets must ensure non-discriminatory access to the information. This means making market data available at the same price and on the same terms and conditions to all customers falling within the same category in accordance with published objective criteria. Any differential in prices charged to different categories of customers must be proportionate to the value which the market data represents to those customers, taking into account: (a) the scope and scale of the market data including the number of financial instruments covered and their trading volume; (b) the use made by the customer of the market data, including whether it is used for the customer’s own trading activities, for resale or for data aggregation. Regulated markets should also have scalable capacities in place to ensure that customers obtain timely access to market data at all times on a non-discriminatory basis.

3.84  The requirement is to charge for the use of market data according to the use made by the individual end users of the market data unless this basis is disproportionate to the cost of making that data available. There should also be arrangements in place to ensure that each individual use of market data is charged only once.

3.85  Regulated markets must offer pre-trade and post-trade transparency data separately in accordance with CDR 2017/572⁴⁵ and charge on the basis of the level of market data disaggregation. They must make market data available without it being bundled with other services.

3.86  An MTF is a multilateral system which brings together multiple third party buying and selling interests in financial instruments—in the system and in accordance with non-discretionary rules—in a way that results in a contract in accordance with Title II of MiFID II. Operating an MTF is an investment service for which authorization by the competent authority of a Member State is required. However, market operators of regulated markets can also operate MTFs without becoming investment firms.

3.87  The definitions of regulated market and MTF are purposefully similar, as it was the policy makers’ intention to reflect the fact that they represent effectively the same organized trading functionality.

3.88  Multilateral means that a trading interest in the system can potentially interact with other opposing trading interests.

(p. 132) 3.89  MTFs are not obliged to operate a ‘technical’ system for matching orders and should be able to operate other trading protocols including requests for quote systems where users are able to trade against quotes they request from multiple providers. A market which is only composed of a set of rules that governs aspects related to membership, admission of instruments to trading, trading between members, reporting, and, where applicable, transparency obligations, without a technical system, is an MTF and the transactions concluded under those rules are considered to be concluded under its systems.

3.90  Buying and selling interests is broadly understood to include orders, quotes, and indications of interest. Such interests must be brought together under the system’s rules or by means of the system’s protocols or internal operating procedures, including procedures embodied in non-discretionary computer software. Non-discretionary rules mean the operator has no discretion as to how interests interact and how transactions are therefore executed, so the operator has to pre-set these.

3.91  Interests must be brought together in such a way as to result in a contract which occurs where execution takes place under the system’s rules or by means of the system’s protocols or internal operating procedures.

3.92  ESMA maintains a list of all MTFs in the EU on its website. The list contains information on the services the MTF provides and the unique market identification code which identifies the MTF in post-trade transparency and transaction reports.

3.93  The organizational requirements that apply to investment firms operating an MTF are the same as those that apply to investment firms providing other investment services or activities and are summarized later.

3.94  In order to be authorized to provide investment services, management bodies must define, oversee, and be accountable for the implementation of governance arrangements which ensure effective and prudent management of the MTF operator, including the segregation of duties in the organization and the prevention of conflicts of interest. These arrangements must be reviewed periodically and monitored by the management body and any deficiencies must be addressed. They must also comply with the following principles:⁴⁶

(p. 133)

• •  the management body must have the overall responsibility for the MTF and approve and oversee the implementation of its strategic objectives, risk strategy, and internal governance;

• •  the management body must ensure the integrity of the accounting and financial reporting systems, including financial and operational controls and compliance with the law and relevant standards;

• •  the management body must oversee the process of disclosure and communications;

• •  the management body must be responsible for providing effective oversight of senior management; and

• •  the chairman of the management body in its supervisory function must not exercise simultaneously the functions of a chief executive officer within the same institution, unless justified and authorized by the competent authorities.

3.95  These arrangements must also ensure that the management body defines, approves, and oversees the organization of the firm including the skills, knowledge, and expertise that is required by personnel, the resources, procedures, and arrangements for the provision of services and activities. A policy for services, activities, products, and operations offered or provided must also be established, which accords with the risk tolerance of the firm as well as the characteristics and needs of the clients of the firm to whom products will be offered or provided, including carrying out appropriate stress testing, where appropriate.

3.96  In addition, a remuneration policy must also be approved and overseen by the management body which aims to encourage responsible business conduct and fair treatment of clients, as well as avoiding conflicts of interest in the relationships with clients.

3.97  The management body must monitor and periodically assess the adequacy and implementation of the firm’s strategic objectives, the effectiveness of their governance arrangements, and the adequacy of policies for the provision of services to clients.

3.98  All members of the management body must be of sufficiently good repute, possess sufficient knowledge, skills, and experience and commit sufficient time to perform their duties.

3.99  At least two persons must effectively direct the business of the firm and all members of the management body and any changes to the management body’s membership must be notified to the competent authority.

3.100  Under MiFID II, competent authorities must be informed of the identities of the shareholders or members that have qualifying holdings and the amounts of those holdings in the investment firm that operates the MTF. A qualifying holding is a direct or indirect holding in an investment firm which represents 10 per cent or more of the capital or voting rights of the investment firm or makes it possible to exercise a significant influence over its management. Competent authorities maintain the discretion to determine (p. 134) whether they are satisfied as to the suitability of these shareholders or members and will take into consideration the need to ensure the sound and prudent management of the firm. Should any close links exist with the investment firm, competent authorities will also assess whether these links will prevent the effective exercise of their supervisory functions. Close links include situations where two or more persons are linked by participation in the form of ownership of 20 per cent or more of the voting rights or capital of an undertaking or of control as defined in MiFID II.

3.101  Importantly, any person or persons acting in concert that acquire a qualifying holding in an investment firm which is an MTF operator or further increase a qualifying holding such that their voting rights or capital reach or exceed 20, 30, or 50 per cent or so that the MTF operator would become its subsidiary must first notify the competent authorities of the MTF operator and provide such information as they may require to ensure the sound and prudent management of the MTF operator having regard to the likely influence of the proposed acquirer. Competent authorities are required to take action against any person that fails to comply with these obligations, such as imposing sanctions against directors and those responsible for management or suspension of the exercise of voting rights attaching to shares held by the relevant persons. If a person acquires a holding despite the opposition of the competent authorities, Member States must at least provide for their voting rights to be suspended or for any votes cast to be invalid.

3.102  MiFID II sets out rules around the time permitted to a competent authority to assess an application for a change in control of an investment firm operating an MTF. They have a maximum of sixty working days from the date they acknowledge in writing that they have received the notification and all the documents they have requested. However, this can be extended by up to twenty or, in some cases thirty working days if they need to request further information. Given the time it takes to gather the information needed to compile an application and that it can take some time for the competent authority to deem an application complete, it is essential for any person seeking to acquire or increase a qualifying holding in an investment firm that operates an MTF to factor in this process and start it as soon as possible. While Member States are not supposed to impose more stringent requirements than those in MiFID II, there are some variations between how different Member States have interpreted and implemented these provisions making it important to check local practice.

3.103  When assessing the application, the competent authorities appraise the suitability of the proposed acquirer and the financial soundness of the proposed acquisition against a number of criteria such as the reputation and financial soundness of the proposed acquirer; the reputation and experience of any person who will direct the business of the MTF operator; and whether the MTF will be able to continue to comply with its prudential requirements and whether its new group will make it possible for the competent authority to supervise it effectively.

(p. 135) 3.104  Further, a person (or persons acting in concert) that disposes of a qualifying holding in an investment firm operating an MTF or reduces its holding so that its proportion of voting rights or capital falls below 20 30, or 50 per cent or so that the MTF operator would no longer be its subsidiary, must also notify the relevant competent authorities.

3.105  Investment firms are subject to a number of organizational requirements which were made more prescriptive under MiFID II. In particular, investment firms operating an MTF must:

• •  have adequate policies and procedures sufficient to ensure compliance of the firm including its managers and employees, as well as appropriate rules governing personal transactions;

• •  maintain and operate effective organizational and administrative arrangements with a view to taking all reasonable steps designed to prevent conflicts of interest from adversely affecting the interests of its clients;

• •  take reasonable steps to ensure continuity and regularity in the performance of investment services and activities through employing appropriate and proportionate systems, resources, and procedures;

• •  ensure, when relying on a third party for the performance of operational functions which are critical for the provision of continuous and satisfactory service to clients and the performance of investment activities on a continuous and satisfactory basis, that it takes reasonable steps to avoid undue additional operational risk;

• •  have sound administrative and accounting procedures, internal control mechanisms, effective procedures for risk assessment, and effective control and safeguard arrangements for information processing systems;

• •  have sound security mechanisms in place to guarantee the security and authentication of the means of transfer of information, minimize the risk of data corruption and unauthorized access, and to prevent information leakage, thereby maintaining the confidentiality of the data at all times; and

• •  arrange for records to be kept of all services, activities and transactions undertaken which are sufficient to enable the competent authority to fulfil its supervisory tasks and to perform the enforcement actions and in particular to ascertain that the investment firm has complied with all obligations including those with respect to clients or potential clients and to the integrity of the market (including the recording of telephone conversations or electronic communications).

3.106  MTFs must have transparent and non-discriminatory rules governing access. They are subject to similar requirements regarding who they may admit as participants as (p. 136) regulated markets (i.e. investment firms, credit institutions, and others that satisfy certain criteria). MTF operators should be able to specify parameters governing the system such as minimum latency provided that this is done in an open and transparent manner and does not involve discrimination.

3.107  MiFID II provides that MTFs must have at least three materially active members or users, each having the opportunity to interact with all the others with respect to price formation. ESMA has explained that this means that any user’s trading interests should be able to interact with those of at least two other users.

3.108  MTFs must establish transparent rules and procedures for fair and orderly trading and establish objective criteria for the efficient execution of orders. They shall have arrangements for the sound management of the technical operations of the facility, including the establishment of effective contingency arrangements to cope with risks of systems disruption.

3.109  Given that MTFs bring together buying and selling interests in accordance with non-discretionary rules, they must establish and implement non-discretionary rules for the execution of orders in their system.

3.110  In summary therefore, MTFs must establish, publish, and maintain and implement transparent and non-discriminatory rules, based on objective criteria, governing access to their facilities.

3.111  An MTF operator cannot execute client orders against proprietary capital or engage in matched principal trading.

3.112  As other investment firms, MTF operators must have arrangements to identify and manage the potential adverse consequences for the operation of the MTF, and for its participants and users, of any conflict of interest between the interests of the MTF, its owners or the operator and the sound functioning of the MTF.

3.113  MTFs must clearly inform participants of their respective responsibilities for the settlement of the transactions executed and have in place arrangements to facilitate the efficient and timely finalization and settlement of those transactions. At the time of writing, no commodity derivatives have been mandated for the clearing obligation for OTC derivatives under EMIR and derivatives traded on an MTF are not required to be cleared under MiFIR either.

3.114  MTFs are required to have arrangements to be adequately equipped to manage the risks to which they are exposed, to identify significant risks to their operation, and to put in place effective measures to mitigate those risks.

3.115  MTFs must have sufficient financial resources to facilitate their orderly functioning, having regard to the nature and extent of the transactions concluded on their markets and the range and degree of risks to which they are exposed.

3.116  MTFs must provide the competent authority with a detailed description of the functioning of the MTF in accordance with RTS 2016/824, including any links to or participation by another trading venue or a systematic internaliser owned by the same investment firm or market operator, and a list of their participants and/or users. Competent authorities shall make that information available to ESMA on request.

3.117  Rules on providing information to clients, suitability and appropriateness, most parts of the best execution rules and the client order handling rules are not applicable to transactions concluded between participants on an MTF or between the MTF and its participants in relation to the use of the MTF. However, importantly, participants in the MTF must comply with these obligations with respect to their clients when, acting on behalf of their clients, they execute their orders through the systems of an MTF.

3.118  MTFs must have transparent rules regarding the criteria for determining the financial instruments that can be traded under their systems. There must be sufficient publicly available information to enable users to form an investment judgement, taking into account both the nature of the users and the types of instruments traded. They might take into account the criteria specified in relation to regulated markets, although these do not technically apply to MTFs.

3.119  MTFs are subject to the same requirements as regulated markets in relation to the suspension and removal of financial instruments from trading, including that MTFs must (p. 138) comply immediately with any instruction from their competent authority to suspend or remove a financial instrument from trading.⁴⁷

3.120  MTFs are subject to the same requirements on systems and controls as regulated markets.

3.121  MTFs are subject to the same transparency requirements as regulated markets.

3.122  An organized trading facility or OTF is a multilateral system which is not a regulated market or an MTF and in which multiple third party buying and selling interests in bonds, structured finance products, emission allowances, or derivatives are able to interact in the system in a way that results in a contract in accordance with Title II of MiFID II. Operating an OTF is an investment service for which authorization is required, unless the OTF is being operated by a market operator.

3.123  It should not include facilities where there is no genuine trade execution or arranging taking place in the system, such as bulletin boards used for advertising buying and selling interests, other entities aggregating or pooling potential buying or selling interests, electronic post-trade confirmation services, or portfolio compression, which reduces non-market risks in existing derivatives portfolios without changing the market risk of the portfolios.

3.124  The OTF was introduced as a new type of trading venue when MiFID II was introduced in 2018 in order to make the financial markets more transparent and efficient and to level the playing field between various venues offering multilateral trading services. It was intentionally broadly defined so that ‘now and in the future it should be able to capture all types of organized execution and arranging of trading which do not correspond to the functionalities or regulatory specifications of existing venues’. There has been much debate in the industry about exactly how broad the OTF concept is intended to be and whether, in particular, it means all voice brokers should be OTFs. This and other questions about how the regulators interpret the OTF obligations are addressed in ESMA’s Questions and Answers (Q&A) on market structures.⁴⁸

(p. 139) 3.125  There are arguably some advantages of executing certain commodity derivatives on an OTF. In particular, wholesale energy products that must be physically settled but which are traded on an OTF are not financial instruments, as compared to those that are traded on a regulated market or MTF. A wholesale energy contract is a contract for the supply of electricity or natural gas where delivery is in the EU or a contract relating to the transportation of electricity or natural gas in the EU.⁴⁹ In addition, commodity derivatives on coal and oil that are traded on an OTF and must be physically settled benefit from a transitional carve out from some of the EMIR provisions until 3 January 2021.⁵⁰ In addition, an OTF (like a regulated market and an MTF) is a trading venue which can be used to execute transactions in derivatives that are subject to the obligation to conclude them on a trading venue or third country equivalent market. That said, no commodity derivatives have been mandated or proposed for the trading obligation at this stage.

3.126  One of the main features that differentiates an OTF from a regulated market and an MTF is the requirement that the execution of orders on an OTF is carried out on a discretionary basis. An OTF operator must exercise discretion only in either or both of the following circumstances: (a) when deciding to place or retract an order on the OTF they operate; and (b) when deciding not to match a specific client order with other orders available in the systems at a given time. However, despite the requirement to exercise discretion, the OTF operator must still comply with any specific instructions received from a client and with its best execution obligations. For the system that crosses client orders the investment firm or market operator operating the OTF may decide if, when and how much of two or more orders it wants to match within the system. An OTF operator may facilitate negotiation between clients so as to bring together two or more potentially compatible trading interests in a transaction provided it can do so in accordance with its obligations. The OTF operator should make clear to users of the venue how it will exercise discretion.

3.127  The discretionary element also results in the other key distinction between an OTF on the one hand and a regulated market or MTF on the other. Although the operators of all three types of trading venue are subject to market facing obligations, only the operator of an OTF is subject to certain client-facing conduct of business obligations as well.

3.128  ESMA maintains a list of all OTFs in the EU on its website. The list contains information on the services they each provide and the unique market identification code which identifies the OTF in post-trade transparency and transaction reports.

3.129  Most of the same requirements apply to OTFs as to MTFs.

3.130  The same organizational requirements apply to investment firms that operate an OTF as to those that operate an MTF.⁵¹

3.131  OTFs must have transparent and non-discriminatory rules governing access. They are subject to similar requirements regarding who they may admit as participants as regulated markets (i.e. investment firms, credit institutions, and others that satisfy certain criteria). OTF operators should be able to specify parameters governing the system such as minimum latency provided that this is done in an open and transparent manner and does not involve discrimination.

3.132  MiFID II provides that OTFs must have at least three materially active members or users, each having the opportunity to interact with all the others with respect to price formation.⁵² ESMA has explained that this means that any user’s trading interests should be able to interact with those of at least two other users. On OTFs, the interaction of trading interest can take place in different ways, including through matched principal trading or market making, to the extent permitted.

3.133  OTFs must establish transparent rules and procedures for fair and orderly trading and establish objective criteria for the efficient execution of orders. They shall have arrangements for the sound management of the technical operations of the facility, including the establishment of effective contingency arrangements to cope with risks of systems disruption.

3.134  In summary therefore, MTFs must establish, publish and maintain, and implement transparent and non-discriminatory rules, based on objective criteria, governing access to their facilities.

3.135  However, there are some additional structural restrictions on OTFs that are different to those that apply to MTFs. Firstly, a client order in an OTF must not be executed against the proprietary capital of either the OTF operator or any other member of its group. An OTF operator can engage another investment firm to carry out market making on the OTF, but that other firm must be independent and therefore cannot have close links (p. 141) with the OTF operator. This is because, as a trading platform, the OTF operator should be neutral.

3.136  However, an OTF operator is permitted to engage in matched principal trading in certain financial instruments, including classes of derivatives that have not been mandated for the clearing obligation under EMIR, provided the client has consented to the process and the operator has arrangements to ensure that it complies with the definition of matched principal trading. As yet, no commodity derivatives have been mandated for the clearing obligation.

3.137  Secondly, the same legal entity cannot operate an OTF and be a systematic internaliser. Further, an OTF must not connect with a systematic internaliser in a way which enables orders in an OTF and orders or quotes in a systematic internaliser to interact. Nor may an OTF connect with another OTF in a way which enables orders in different OTFs to interact.

3.138  As other investment firms, OTF operators must have arrangements to identify and manage the potential adverse consequences for the operation of the OTF, and for its participants and users, of any conflict of interest between the interests of the OTF, its owners or the operator and the sound functioning of the OTF.

3.139  OTFs must clearly inform participants of their respective responsibilities for the settlement of the transactions executed and have in place arrangements to facilitate the efficient and timely finalisation and settlement of those transactions. At the time of writing, no commodity derivatives have been mandated for the clearing obligation for OTC derivatives under EMIR and derivatives traded on an OTF are not required to be cleared under MiFIR either.

3.140  OTFs must have sufficient financial resources to facilitate their orderly functioning, having regard to the nature and extent of the transactions concluded on their markets and the range and degree of risks to which they are exposed.

3.141  OTFs must provide the competent authority with a detailed description of the functioning of the OTF in accordance with RTS 2016/824, including any links to or (p. 142) participation by another trading venue or a systematic internaliser owned by the same investment firm or market operator, and a list of their participants and/or users. Competent authorities shall make that information available to ESMA on request.

3.142  The competent authority of a prospective or actual OTF operator may require a detailed explanation why the system does not correspond to and cannot operate as a regulated market, MTF, or systematic internaliser, a detailed description as to how discretion will be exercised, in particular when an order to the OTF may be retracted and when and how two or more client orders will be matched within the OTF. ESMA also highlights that the OTF operator should be able to explain to its national competent authority the rationale underpinning the exercise of discretion, such as the set of reasons and the logical basis for not matching two opposite buying and selling interests. In addition, an OTF operator must provide the competent authority with information explaining its use of matched principal trading. The competent authority shall monitor an OTF operator’s engagement in matched principal trading to ensure that it continues to fall within the definition of such trading and that its engagement in matched principal trading does not give rise to conflicts of interest between the investment firm or market operator and its clients.

3.143  As noted earlier, execution of orders on an OTF must be carried out on a discretionary basis. The industry found it difficult to understand what type of discretion counts for these purposes so ESMA has answered a number of questions on this subject in its Questions and Answers on Market Structures.⁵³ These include that ESMA understands the requirement to mean that the OTF has options to consider for the execution of a client’s order and exercises a judgement as to the decision to make and the way forward. ESMA considers that the exercise of discretion can usefully be split into a) order discretion and b) execution discretion. When an investment firm or a market operator receives an order from a client, ‘order discretion’ refers to the judgement exercised by the OTF operator whether to place the order at all on the OTF, whether to place the whole order or just a portion of it on the OTF, and when to do so. Similarly, and as opposed to the operator of an MTF which may not withdraw an order from the MTF at its own initiative unless for fair and orderly market purposes, the operator of the OTF is expected to make a judgement as to whether and when an order should be retracted from the OTF. This may be the case where, at a given point of time, the OTF operator considers that a more favourable outcome would be obtained by executing the order on another execution venue foreseen in the best execution policy. The OTF operator may also have placed the order on the OTF, sent it to another trading venue simultaneously, (p. 143) subsequently decided to have the order executed on the other trading venue and retracted it from the OTF. The exercise of order discretion would always have to comply with the OTF best execution policy and with client order handling rules. Where clients would be providing a specific instruction to the operator of the OTF, the OTF operator would not be considered as exercising order discretion when complying with that specific instruction.

3.144  The exercise of discretion at execution level has to be in compliance with client specific instructions and the best execution policy. ESMA is of the view that the mere implementation of client specific instructions or of best execution obligations would not be the exercise of discretion. The operator of the OTF is expected to exercise a judgement as to if, when, and how much of two matching orders in the system should be matched. Finally, ESMA highlights that the exercise of discretion, be it ‘order discretion’ or ‘execution discretion’, should not be just a possibility foreseen in the rules of the OTF and in the best execution policy of the OTF operator. Discretion has to be actually implemented by the operator of the OTF as part of its ordinary course of business and should be a key part of its activities. Random placing, retracting, matching, or non-matching of orders on the OTF would not be considered as the exercise of discretion.

3.145  Given that OTF operators must carry out execution on a discretionary basis, they must comply with certain investor protection rules including those on providing information to clients, suitability and appropriateness, best execution, and client order handling in relation to the transactions concluded on an OTF. This is another factor that makes operating an OTF somewhat different than operating an MTF because the OTF operator must comply with both client facing and market facing obligations.

3.146  In addition, any market operator authorized to operate an OTF should comply with Chapter 1 of Directive 2014/65/EU regarding conditions and procedures for authorization of investment firms.

3.147  OTFs must have transparent rules regarding the criteria for determining the financial instruments that can be traded under their systems. There must be sufficient publicly available information to enable users to form an investment judgement, taking into account both the nature of the users and the types of instruments traded. They might take into account the criteria specified in relation to regulated markets, although these do not technically apply to OTFs.

3.148  In addition, any market operator authorized to operate an OTF should comply with Chapter 1 of Directive 2014/65/EU regarding conditions and procedures for authorization of investment firms.

3.149  OTFs are subject to the same requirements as regulated markets in relation to the suspension and removal of financial instruments from trading, including that OTFs must comply immediately with any instruction from their competent authority to suspend or remove a financial instrument from trading.⁵⁴

3.150  OTFs are subject to the same requirements on systems and controls as regulated markets.

3.151  OTFs are subject to the same transparency requirements as regulated markets.

3.152  The Organized Market Place, abbreviated as OMP, is one of the key concepts in REMIT. This is particularly true in relation to the obligation to report the details of orders and transactions in wholesale energy products.

3.153  An organized market place means: (i) a multilateral system which brings together or facilitates the bringing together of multiple third party buying and selling interests in wholesale energy products in a way that results in a contract; or (ii) any other system or facility in which multiple third-party buying and selling interests in wholesale energy products are able to interact in a way that results in a contract.⁵⁵

3.154  The wide definition of OMP indicates that the intention of the drafters was to capture not just traditional trading venues, such as regulated markets and multilateral trading facilities, but also broker crossing networks which, at the time the Implementing Regulation came into force, were not impacted by the new type of trading venue in MiFID II known as an organized trading facility (OTF). In the intervening period, some of these broker crossing networks have become authorized as OTFs.

3.155  Art. 2(1) of the Implementing Regulation requires ACER to publish a list of OMPs and to update this list as necessary in a timely manner.⁵⁶ OMPs must register with ACER in order to appear on the list. It is therefore not an authorization regime as such. Firms which determine that they fall within the definition of OMP need to complete the OMP registration form, provide ACER with either a Market Identifier Code or a Legal Entity Identifier, submit reference data for each wholesale energy product that will be admitted to trading on the OMP, and provide the details of the Registered Reporting Mechanism (RRM) that will be used to report transactions on behalf of the OMP. The ongoing obligations of OMPs are relatively few, and include the submission of reference data, reporting details of orders to trade and transactions, and detecting market abuse and insider trading.

3.156  As noted earlier, one of the main functions of OMPs is to report the details of transactions and orders to trade in standard contracts. Standard contract means a contract relating to a wholesale energy product which is admitted to trading at an OMP, irrespective of whether or not the transaction actually takes place on that market place.⁵⁷ OMPs where a contract in a wholesale energy product was executed or an order was placed are obliged to offer a data reporting agreement to market participants in respect of those contracts and orders.⁵⁸ However, there is no obligation on an OMP to become a RRM meaning that they are free to delegate the actual reporting to a third party, provided that the third party is itself a RRM.

3.157  In addition to facilitating reporting, OMPs play an important role in the monitoring and reporting of breaches of the prohibitions against insider trading and market manipulation set out in Arts 3 and 5 of REMIT. In its Questions and Answers on REMIT, ACER clarified that OMPs fall within the definition of persons professionally arranging transactions (PPATs).⁵⁹

3.158  PPATs must notify the relevant national regulatory authority of transactions that breach the insider dealing or market manipulation prohibitions and are required to establish (p. 146) and maintain effective arrangements and procedures to identify such breaches. In this respect, the role of OMPs is similar to the role of trading venues in identifying market abuse in relation to the trading of financial instruments under MiFID II.⁶⁰

3.159  There are three channels for reporting the details of wholesale energy products executed at OMPs: OMPs, trade matching systems, or trade reporting systems.⁶¹

3.160  The default solution is that the reporting of details of wholesale energy products executed at an OMP should be carried out by the OMP concerned. In this regard, the OMP where orders are submitted and trades executed has to offer a data reporting agreement if requested by market participants. However, the OMP and/or market participants can choose another OMP, a trade matching system, and/or a trade reporting system, i.e. a third party RRM, to report data.

3.161  Trade matching system is not defined in the Implementing Regulation, but ACER has stated in its Questions and Answers on REMIT that it means a third party electronic matching system to match wholesale energy contract transactions, including the matching system for buy and sell orders to match transactions in a wholesale energy product. As an example, ACER specifically refers to third party trade confirmation systems.⁶²

3.162  The EU Emissions Trading Scheme (EU ETS) is the legal framework for greenhouse gas emission allowances in the EU.⁶³ The EU enacted the EU ETS to meet its commitments to reduce greenhouse gas emissions under the Kyoto Protocol. The EU ETS is a cap and trade scheme that aims to reduce greenhouse gas emissions by setting limits on the ability of participants in specified sectors of the economy to emit carbon dioxide (CO2).

3.163  An EU ETS emissions allowance (EUA) represents an entitlement to emit one metric tonne of CO2 into the atmosphere. At the end of each EU ETS year, participants that are (p. 147) subject to the scheme must surrender EUAs equal to the total volume of actual emissions from their installations for that year. In order to facilitate EU ETS compliance, participants are permitted to purchase and sell EUAs.

3.164  EUAs are traded on the primary and secondary markets. EU ETS auctions constitute the primary market for EUAs. The auctioning of EUAs is governed by Commission Regulation (EU) No. 1031/2010 (the EU ETS Auctioning Regulation).⁶⁴ The EU ETS Auctioning Regulation establishes two types of auctioning platform: a common EU auction platform; and opt-out platforms for use in Member States that decide not to participate in the common EU platform. Importantly, Art. 35(1) of the EU ETS Auctioning Regulation specifies that auctions may only be conducted on a platform that is authorized as a regulated market.⁶⁵

3.165  The EU Commission considers the use of a common EU auction platform to be the most cost efficient approach whilst also ensuring respect for the principles of non-discrimination, transparency, and simplicity.⁶⁶ In 2012 the European Energy Exchange AG (EEX) was appointed as the first common EU auction platform following a competitive tendering process. EEX was re-appointed by the EU Commission in 2016.

3.166  The UK, Germany, and Poland have opted-out of the common EU auction platform, although Germany has appointed EEX as its opt-out platform in any event. In the UK, ICE Futures Europe conducts auctions in EUAs on behalf of the government. At present, Poland continues to use the common EU auction platform pending the appointment of its own platform.

3.167  It is not entirely clear what impact Brexit will have on the UK’s continued participation in the EU ETS, but at the moment it appears that the UK will remain part of the EU ETS, at least until the end of the current compliance phase in 2020. The European Commission has clarified that the UK will not participate in the EU ETS for 2019 in a no-deal scenario. The UK government will remove requirements relating to the surrender of emissions allowances under the EU ETS for the 2019 compliance year onwards.⁶⁷

3.168  Authorization under MiFID II is valid for the entire EU and allows an investment firm to provide the services or perform the activities, for which it has been authorized, throughout the EU, either through the right of establishment, including through a branch, or through the freedom to provide services.

3.169  MiFID II contains a passporting regime which means that an investment firm authorized and supervised by a competent authority to provide investment services including operating an MTF or OTF and specified ancillary services can provide the same investment services and ancillary services to persons in other Member States without also requiring authorization in those Member States. As indicated earlier, there are two types of passport: the branch passport, which involves establishing a branch in the host Member State, and the services passport, which involves the MTF or OTF operator providing its services from its home Member State to persons in other Member States on a cross-border basis. The process and requirements for each are a little different from one another.

3.170  In relation to MTFs and OTFs specifically, Member States are required to allow investment firms and market operators operating an MTF or OTF from another Member State to provide appropriate arrangements on their territory to facilitate access to and trading on those markets by remote users, members, and participants established in their territory. The home Member State of the MTF or OTF may be required to communicate to the competent authority of the host Member State the identity of the remote members or participants of the MTF or OTF.⁶⁸

3.171  Passport rights only apply to investment firms and credit institutions that are established in the EU. Entities established incorporated in a third country which establish a branch in a Member State and get it authorized cannot benefit from passporting rights and must instead set up additional licensed branches in other Member States if they wish to operate there. However, MiFID II provides for a third country regime that goes some way to potentially resolving this. A third country firm may provide investment services with or without ancillary services to eligible counterparties and per se professional clients established throughout the EU without the establishment of a branch and without the Member States imposing any additional requirements by registering with ESMA. However, ESMA can only register a third country firm where certain conditions (p. 149) have been satisfied, including that the EU Commission has adopted a decision stating that the legal and supervisory arrangements of that third country ensure that firms authorized and supervised comply with prudential and conduct of business requirements that have equivalent effect to those in MiFID II and MAR. At the time of writing, no third countries have been deemed equivalent for these purposes and therefore third country firms cannot apply for registration under this regime yet.

3.172  There is a transitional provision which means that third country firms may provide investment services to eligible counterparties and per se professional clients in accordance with the national regimes of Member States until an equivalence decision is adopted. Some Member States, such as the UK, have exemptions in their domestic regimes, which allow for this in certain circumstances.

3.173  It is also possible for third country firms to provide investment services to retail clients and elective professional clients in the EU if they establish a branch in each relevant Member State and certain other criteria are satisfied.

3.174  Regulated markets do not benefit from the same type of passporting rights as investment firms. In addition, Member States must require that investment firms from other Member States that are authorized to execute client orders or deal on own account have the right of membership or have access to regulated markets established in their territory. This must be permitted both directly, by allowing such firms to set up branches in the host Member State and indirectly, by becoming remote members or having remote access to the regulated market without having to be established in the home Member State of the regulated market. Member States must not impose additional requirements on firms exercising this right.⁶⁹

3.175  There are also various provisions requiring Member States to:

• •  permit investment firms from other Member States to access CCPs and clearing and settlement systems in their territory for the purpose of finalizing transactions;⁷⁰

• •  require regulated markets to offer their members and participants the right to designate the system for settling transactions undertaken on their markets;⁷¹ and

• •  not prevent regulated markets or MTFs from entering into appropriate arrangements with a CCP or settlement system in another Member State with a view to providing services for trades concluded by participants under their systems. The competent authority of a regulated market or MTF may only oppose the use of a central counterparty or settlement system in another Member State where necessary to maintain the orderly functioning of the regulated market or MTF and taking into account the conditions for settlement systems.⁷²

3.176  The Chicago Mercantile Exchange (CME) Group comprises four designated contract markets (DCMs) registered with the Commodity Futures Trading Commission (CFTC): CME, CBOT, New York Mercantile Exchange (NYMEX), and COMEX (formerly known as Commodity Exchange Inc). As DCMs, these four exchanges have self-regulatory responsibilities and each maintain their own set of rules.⁷³ DCMs are traditional US derivative exchanges that are regulated by the CFTC on which standardized derivative contracts are executed. However certain OTC derivatives transactions, which previously were entered into bilaterally or off-exchange, must now also be executed on a DCM or a swap execution facility (SEF). CME Group Inc. is also listed on NASDAQ.

3.177  Through these exchanges, CME offers a wide range of global benchmark products across all major asset classes, including futures and options based on interest rates, equity indices, foreign exchange, energy, agricultural products, and metals. In the commodity derivatives field COMEX offers various metal products, such as gold, copper, and silver futures and options; CBOT offers various agricultural products such as wheat, soybean, and commodity index futures; NYMEX offers energy products such as crude oil, electricity, and natural gas futures; and CME offers various agricultural products such as live cattle options and cash settled butter options.⁷⁴ CME provides electronic trading globally on its CME Globex platform. CME also offers clearing and settlement services across asset classes for exchange-traded and OTC derivatives through CME Clearing, which is part of CME Inc. CME Inc. is regulated as a derivatives clearing organization by the CFTC, but is also recognized as a central counterparty under EMIR.

3.178  CME also operates a swap data repository in the US and trade repositories in Europe, Singapore, Australia, and Canada.⁷⁵

3.179  The London Metal Exchange (LME) is a regulated market established and located in the UK. It is owned by Hong Kong Exchanges & Clearing Limited and as a Recognized Investment Exchange (RIE) and regulated market, is regulated directly by the FCA.

3.180  As the name suggests, the LME is an exchange for metals, where both spot contracts and derivatives on metals are traded. Participants can trade six different types of contract (p. 151) against fourteen underlying metals, both precious and base, on a choice of three regulated platforms. LME’s contract types include various types of futures and options on different types of base and precious metals. These include aluminium, copper, zinc, nickel, lead, tin, gold, silver, platinum, and palladium, among others.⁷⁶

3.181  These contracts can be traded on a choice of three trading venues; (i) The Ring, where prices are discovered during five-minute ‘Ring’ sessions for each metal; (ii) LMEselect, an electronic platform for the trading of all LME contracts; and (iii) the Inter-office telephone market, where all LME contracts can be traded over the telephone twenty-four hours a day.

3.182  LME has a number of categories of member, each of which has different rights:

• •  Category 1 members have the exclusive right to trade LME contracts by open outcry in the Ring, in the telephone market, and on LMEselect and are entitled to issue client contracts to their clients. As clearing members, they are permitted to clear trades on their own behalf and on behalf of their clients and, as a result, must be members of the clearinghouse;

• •  Category 2 members are clearing members and are permitted to trade LME Contracts in the telephone market and on LMEselect and issue client contracts. As clearing members, they are permitted to clear trades on their behalf and on behalf of their customers and, as a result, must be members of the clearinghouse;

• •  Category 3 members are clearing members and are permitted to trade LME contracts in the telephone market and on LMEselect, but are not permitted to issue client contracts, being proprietary traders. As clearing members, they are permitted to clear trades on their own behalf only and, as a result, must be members of the clearinghouse;

• •  Category 4 members are not clearing members and must appoint a designated clearing member to clear trades on their behalf. These members are permitted to trade client contracts in the telephone market and on LMEselect and are permitted to issue client contracts;

• •  Category 5 members may be customers of Category 1, 2 or 4 members, in which case they receive client contracts, but are not permitted to issue them, or they may be physical market participants who wish to be associated with the LME brand. Category 5 members are not required to be regulated;

• •  Category 6 members are individuals within the industry who wish to be close to the LME community; and

• •  Category 7 is an honorary membership conferred on individuals at the discretion of the LME Directors.⁷⁷

(p. 152) 3.183  LME members trades are executed with one another or the clearinghouse and, where they are trading for a client, a client contract is created. LME Clear provides clearing and settlement services for all Ring, electronic, and telephone trades. LME Clear is a central counterparty authorized under EMIR, whose lead supervisor is the Bank of England.

3.184  The Intercontinental Exchange (ICE) operates twelve exchanges and seven clearing houses throughout North America, Europe, and Asia.⁷⁸ Its network of regulated exchanges offer spot and derivative trading through more than 8,000 listed contracts across energy, agriculture, interest rates, credit, currencies, single stock, and equity indexes.

3.185  Its European exchange, ICE Futures Europe, is based in London and is a recognized investment exchange and regulated market supervised by the FCA. It is also an OMP under REMIT and an Emission Allowance Platform under the EU ETS Auctioning Regulation. ICE Futures Europe offers futures and options contracts for crude oil, interest rates, equity derivatives, natural gas, power, coal, emissions, and soft commodities. ICE Futures Europe is now home to a large proportion of the world’s crude and refined oil futures trading. For example, it offers Brent crude and gasoil futures, as well as coal, natural gas, and fuel oil futures.⁷⁹

3.186  Transactions entered into on ICE Futures Europe are cleared through ICE Clear Europe. All members of ICE Futures Europe must either be clearing members of ICE Clear Europe, or otherwise have arrangements in place with a clearing member. ICE Clear Europe is the clearing house for many contracts traded on ICE Futures Europe. It is an EMIR-authorized central counterparty and its lead supervisor is the Bank of England. ICE also has an authorized central counterparty in the Netherlands, ICE Clear Netherlands, and a clearinghouse in the US, ICE Clear US, which is on ESMA’s list of recognized third country central counterparties under EMIR.

3.187  In addition, ICE has a trade repository, Trade Vault. Trade Vault connects to a range of institutions, including clearing houses, exchanges, middleware platforms, and electronic trade confirmation services (including eConfirm), allowing customers to leverage existing workflows and connectivity to fulfil reporting obligations across North America, Europe, and Asia. Trade Vault is a single user interface that fulfils a full range of global regulatory reporting obligations through one application. From a regulatory perspective, Trade Vault is already registered to provide trade repository services under (p. 153) CFTC’s Dodd-Frank and EMIR, the Eastern Canadian Provincial Rules and Policies, and ACER’s REMIT as a RRM.⁸⁰

3.188  European Energy Exchange (EEX) is a German energy exchange established under the German Exchange Act and is a regulated market within the context of MiFID II.⁸¹ It is also an OMP under REMIT and an Emission Allowance Platform under the EU ETS Auctioning Regulation. EEX operates a physical commodity and derivatives exchange and offers a power derivatives market where physical futures on power can be traded. EEX also offers trading for derivatives contracts that allow hedging of volatile prices for freight rates of various types of ships and sea trade routes (forward freight agreements). It also offers financially settled derivatives contracts on dairy products.

3.189  The contracts can be traded through EEX’s regulated market or OTF and clearing and settlement of all transactions is provided by the clearinghouse European Commodity Clearing AG, which is a German central counterparty authorized under EMIR (ECC). Trading on the regulated market comprises the conclusion of spot and derivatives market transactions in the EEX trading systems either through an order book trading or the registration of trades. Trading can only be carried out or brokered by an approved exchange participant or by an auctioneer.⁸² Trading on the OTF grants companies access to trading as either trading participants or non-trading brokers, provided they satisfy the necessary preconditions. Access can include individual or all products which can be traded at the OTF.⁸³

3.190  globalCOAL is the provider of an online trading platform for physical and financial coal and promotes the development of a liquid and transparent thermal and metallurgical coal market.⁸⁴ globalCoal Limited is authorized and regulated by the FCA with permission to arrange transactions in commodity derivatives and contracts for difference.

3.191  globalCOAL’s online trading platform serves as an electronic marketplace where participants bid, offer, and transact cargos of physical coal. globalCOAL is also the architect (p. 154) of SCoTA a standard coal trading agreement which has become the coal market’s contract of choice. A variety of physical and financial contracts can be traded on the globalCOAL platform through each of these key hubs; ARA (North-West Europe), HCCA (Australia), Newcastle (Australia), Richards Bay (South Africa), Columbia (COL), and Indonesia.⁸⁵

3.192  globalCOAL also partners with the financial clearinghouse ICE, which offers a portfolio of financially settled coal futures for the world’s busiest international coal hubs: Newcastle (Australia), Rotterdam (Europe), and Richards Bay (South Africa).⁸⁶

3.193  globalCOAL considers that the globalCOAL indices are benchmarks and comply with the IOSCO principles for financial benchmarks for this purpose.⁸⁷ globalCOAL administers the globalCOAL NEWC Index, the globalCOAL RB Index, the globalCOAL DES ARA Index, and the globalCOAL INDO 4200 Index.⁸⁸

3.194  To view prices or transact cargos on the globalCOAL platform, companies must become market members. Members of globalCOAL include major coal producers, utilities, international trading houses, and steel plants in all parts of the world.

3.195  S&P Global Platts (Platts) is a provider of information, benchmark prices, and analytics for the energy and commodities markets.⁸⁹ Platts publishes daily news, commentary fundamental market data and analysis, and thousands of daily price assessments that are widely used as benchmarks in the physical and futures markets. Coverage of information includes petroleum, oil, natural gas, LNG, power, coal, shipping, petrochemicals, metals, and agriculture.

3.196  Platts’ service is used by traders, analysts, risk managers, purchasing agents, and other professionals. Platts engages with market participants, industry organizations, and regulators through forums, training sessions, and one-on-one meetings and consults to develop methodologies that meet the markets’ needs. Platts has adhered to the IOSCO PRA Principles since 2013 and is preparing for implementation of the EU Benchmark Regulation. Platts is interacting with national competent authorities to understand how they supervise administrators under the new requirements. Platts is also considering the impact of Brexit on the implementation of the Benchmark Regulation.

3.197  The UK has implemented the MiFID II requirements applicable to regulated markets in Part XVIII of the Financial Services and Markets Act 2000. These provisions are supplemented by the Financial Services and Markets Act 2000 (Recognition Requirements for Investment Exchanges and Clearing Houses) Regulations 2001 (the Recognition Requirements Regulations) and the FCA’s rules for recognized investment exchanges set out in the REC part of its Handbook. The UK describes UK regulated markets as recognized investment exchanges and considers that they need to be exempt from the UK’s authorization regime as otherwise they would be carrying on regulated investment activity in the UK. A recognized investment exchange is therefore exempt from the general prohibition as respects any regulated activity which is carried on as a part of the exchange’s business as an investment exchange or for the purposes of, or in connection with, the provision by the exchange of services designed to facilitate the provision of clearing services by another person.

3.198  A body corporate or an unincorporated association may apply to the FCA for an order declaring it to be an RIE. If the FCA considers that the applicant satisfies the recognition requirements, it will make an order declaring it to be an RIE. The recognition requirements are those set out in the Recognition Requirements Regulations and directly applicable to EU legislation such as MiFIR, but the FCA may have regard to any information which it considers to be relevant. The application must be determined by the end of six months, beginning on the date on which the FCA receives a complete application, unless the applicant is an overseas applicant.⁹⁰ Chapter 5 of REC contains guidance for UK entities that are considering making an application on the information they need to provide to the FCA and the process that the FCA will follow.

3.199  The FCA may revoke a recognition order it has made with the consent of the RIE. The FCA may also revoke a recognition order for an RIE if it appears to the FCA that the RIE has not carried on the business of an investment exchange during the period of twelve months beginning with the day on which the recognition order took effect, has not carried on the business of an investment exchange for six months ending with the relevant day, or has failed, or is likely to fail, to comply with any obligation imposed on it by a directly applicable EU regulation specified by HM Treasury. S296 Before making a revocation order, the FCA must give written notice of its intention to do so stating the (p. 156) reasons why and the RIE may make representations to the FCA, which must have regard to them. The procedure is set out in further detail in REC 4.8.⁹¹

3.200  In order to become an RIE and remain an RIE, the RIE must be able to satisfy the recognition requirements. As noted earlier, these are set out in the Recognition Requirements Regulations and guidance is provided on each of them by the FCA in Chapter 2 of REC. Many of the recognition requirements implement the requirements on regulated markets in MiFID II. However, there are a few requirements that are specific to the UK. These include:

3.201  The exchange must have financial resources sufficient for the proper performance of its functions as a recognized investment exchange. In considering whether this requirement is satisfied, the FCA must take into account all the circumstances, including the exchange’s connection with any person, and any activity carried on by the exchange, whether or not it is an exempt activity.

3.202  REC 2.3 provides more detailed guidance about the risks and factors the FCA may take into account. The FCA gives RIEs individual guidance on the amount of eligible financial resources they should hold in respect of operational and other risks. However, this would normally be eligible financial resources not less than the greater of:

• •  an amount calculated under the standard approach;

• •  an amount calculated under the risk-based approach; and

• •  net capital not less than the amount of the eligible financial resources calculated under the standard approach.

3.203  Eligible financial resources consist of liquid financial assets held on the RIE’s balance sheet, including cash and liquid financial instruments that have limited market and credit risk and are capable of being liquidated with minimal adverse price effect. Net capital should be in the form of equity. Under the standard approach, the amount of eligible financial resources is equal to six months of operating costs, normally based on the RIE’s most recent audited annual accounts. The idea is that the RIE should have sufficient liquid financial assets to cover the costs that would be incurred during an orderly wind down of the RIE’s activities.

3.204  The risk-based approach, on the other hand, is intended to ensure that sufficient financial resources are maintained at all times such that an RIE would not be prevented from implementing an orderly wind down as a result of the financial impacts of stress events affecting its business or the markets in which it operates. This is calculated by adding (p. 157) together the amount estimated to absorb the potential business losses that a business of its nature, scale, and complexity might incur in stressed, but plausible market conditions and the amount estimated to effect an orderly closure. For this reason, RIEs are expected to provide the FCA with an annual financial risk assessment identifying the risks to their business at least once in every twelve-month period. The FCA would normally consider that an RIE is failing to meet the recognition requirements if it holds eligible financial resources less than the amount calculated under the standard approach so it expects them to hold an operational buffer of a sufficient amount in excess of this minimum, consistent with the risk based approach. If the amount calculated under the risk based approach is sufficiently greater than the amount calculated under the standard approach to provide a sufficient buffer, that amount can be used. If not, the FCA would expect the RIE to hold additional financial resources sufficient to constitute an operational risk buffer.⁹²

3.205  The exchange must adopt appropriate measures to reduce the extent to which the exchange’s facilities can be used for a purpose connected with market abuse or financial crime, and to facilitate their detection and monitor their incidence. REC 2.10 provides guidance on this requirement.

3.206  Where the exchange’s facilities include making provision for the safeguarding and administration of assets belonging to users of those facilities, satisfactory arrangements must be made for that purpose. REC 2.11 provides guidance on this recognition requirement.

3.207  The RIE must make available to the public, without any charges, data relating to the quality of execution of transactions on the trading venues operated by the exchange on at least an annual basis. Reports must include details about price, costs, speed, and likelihood of execution for individual financial instruments.

3.208  The exchange must be able and willing to promote and maintain high standards of integrity and fair dealing in the carrying on of regulated activities by persons in the course of using the facilities provided by the exchange. The exchange must be able and willing to cooperate, by the sharing of information or otherwise, with the FCA, with any other authority, body, or person having responsibility in the UK for the supervision or regulation of any regulated activity or other financial service, or with an overseas regulator. Further guidance on this recognition requirement is set out in REC 2.13.

3.209  The exchange must ensure that appropriate procedures are adopted for it to make rules, for keeping its rules under review and for amending them. The procedures must include procedures for consulting users of the exchange’s facilities in appropriate cases. The exchange must consult users of its facilities on any arrangements it proposes to make for dealing with penalty income. Further guidance on this recognition requirement is set out in REC 2.14.

3.210  Arrangements made for monitoring and enforcing compliance with the exchange’s rules and arrangements and for monitoring transactions to identify disorderly trading must include procedures for investigating complaints made to the exchange about the conduct of persons in the course of using the exchange’s facilities and the fair, independent, and impartial resolution of appeals against decisions of the exchange. Where such arrangements include provision for requiring the payment of financial penalties, they must include arrangements for ensuring that any amount so paid is applied only towards meeting expenses incurred by the exchange in the course of the investigation of the breach in respect of which the penalty is paid, or in the course of any appeal against the decision of the exchange in relation to that breach; for the benefit of users of the exchange’s facilities; and/or for charitable purposes. Further guidance on this recognition requirement is set out in REC 2.15.

3.211  The exchange must have effective arrangements for the investigation and resolution of complaints arising in connection with the performance of, or failure to perform, any of its regulatory functions. However, this does not extend to complaints about the content of rules made by the exchange or complaints about a decision against which the complainant has the right to appeal. The arrangements must include arrangements for a complaint to be fairly and impartially investigated by a person independent of the exchange. Such person must have the power to recommend that the exchange makes a compensatory payment to the complainant and/or remedies the matter complained of. Further guidance on this recognition requirement is set out in REC 2.16.

3.212  The exchange must have in place effective procedures for its employees to report potential or actual infringements of the Recognition Requirements Regulations, provisions of the Financial Services and Market Act 2000 (FSMA), and its subordinate legislation transposing MiFID II, MiFIR, and directly applicable EU regulations made under either of them, internally through a specific, independent, and autonomous channel.

3.213  The exchange must have default rules which, in the event of a member being or appearing to be unable, or appearing to be likely to become unable, to meet its obligations (p. 159) in respect of one or more market contracts, enable action to be taken in respect of unsettled market contracts to which that member is a party. Market contracts are contracts entered into by a member or designated non-member of the exchange with a person other than the exchange which are either contracts made on the exchange or contracts in the making of which the member or designated non-member was subject to the rules of the exchange.

3.214  The rules must enable action to be taken in respect of all unsettled market contracts, other than those entered into for the purposes of or in connection with the provision of clearing services for the exchange. In fact, sometimes the default rules of UK exchanges do not apply to many market contracts because most of the contracts formed pursuant to their rules are also subject to the rules of the relevant central counterparty and it is provided that these should take precedence. Where default rules are required, the Recognition Requirements Regulations set out what the default rules should provide for in fairly prescriptive detail. The Companies Act 1989 contain provisions which protect action taken by an RIE under its default rules from the normal operation of insolvency law, which might otherwise leave this action open to challenge by a relevant insolvency practitioner.

3.215  Whether the recognition requirement is derived from MiFID II or not, it is important to read the requirements in the Recognition Requirements Regulations in the context of the guidance in REC 2 as the FCA sets out guidance on how its interprets them. In particular, the FCA confirms that an exchange may satisfy the requirements by arranging for another person to perform certain functions under an outsourcing arrangement, but emphasizes that the exchange remains responsible for such performance. In addition, the exchange must be able to demonstrate to the FCA that any service provider ifs fit and proper and willing and able to perform the function.

3.216  The FCA must not make a recognition order it if appears that a regulatory provision will impose an excessive requirement on the persons directly or indirectly affected by it. Equally, once an RIE is recognized, the FCA may direct it not to make any regulatory provision if it appears that the proposed provision will impose a requirement on persons affected by it that is excessive. A regulatory provision is any rule, guidance, arrangements, policy, or practice and is considered excessive if it is not required under EU or UK law and either it is not justified as pursuing a reasonable regulatory objective, or it is disproportionate to the end to be achieved. In considering whether a requirement is excessive the FCA must have regard to all the relevant circumstances, including the effect of existing legal and other requirements; the global character of financial services and markets and the international mobility of activity; the desirability of facilitating innovation; and the impact of the proposed provision on market confidence. Any provision made in contravention of such a direction is of no effect.⁹³

(p. 160) 3.217  For this reason, an RIE that proposes to make any regulatory provision must give written notice of its proposal to the FCA unless it falls within a one of certain exceptions set out in Chapter 3 of REC. Chapter 3 of REC also sets out the form and contents of the notice required and the information that is required to be submitted with it.⁹⁴ Where the RIE is required to give notice to the FCA of a proposal to make regulatory provision, the RIE must not make the regulatory provision before that notice is given or before the end of a specified time period.

3.218  The FCA expects to have an open, cooperative, and constructive relationship with RIEs to ensure it has a broad picture of their activities and their ability to comply with the recognition requirements. This complements the RIE’s obligations to provide specified information as set out in REC 3. Where RIEs develop and adapt their businesses, they should take steps to assure themselves that they can continue to satisfy the recognition requirements, but also keep the FCA informed of their plans.

3.219  Chapter 4 of REC sets out information on various areas of the supervision of an RIE, some of which are mentioned in other parts of this section.

3.220  The FCA may make rules requiring an RIE to give it notice of certain events and specified information, all of which are set out in Chapter 3 of REC. In particular, an RIE must notify the FCA without delay if it alters or revokes any of its rules or guidance, or makes new rules or issues new guidance. Equally, if an RIE makes a change in the arrangements it makes for the provision of clearing services in respect of transactions effected on the exchange or in the criteria which it applies when determining to whom it will provide clearing services, it must give written notice to FCA and the Bank of England.⁹⁵

3.221  The FCA may require an RIE to give it such information as it reasonably requires for the exercise of its functions under FSMA and in order to satisfy itself that the RIE is complying with any qualifying EU provision that is specified for this purpose by HM Treasury.⁹⁶

3.222  The FCA has various powers in relation RIEs. If the FCA is not able to obtain information it needs through its normal relationship with the RIE, it may require the RIE or any person connected with it (including a person who is or has at any time been a member of the RIE’s group or a controller of the RIE) to provide information within a reasonable timeframe.⁹⁷ The FCA can also exercise its power under FSMA against an RIE, where the FCA can, by giving written notice, appoint a skilled person to provide it with information, produce documents, or provide it with a report. The guidance in Chapter 5 (p. 161) of the Supervision Manual of the FCA Handbook explains how the FCA will exercise this power.

3.223  If it appears to the FCA that an RIE has failed, or is likely to fail, to satisfy the recognition requirements or has failed to comply with any other obligation imposed on it by or under FSMA or any directly applicable EU regulation specified by HM Treasury, the FCA may direct the RIE to take specified steps for the purpose of securing its compliance with those obligations. Those steps may include granting to the FCA access to the premises of the RIE for the purpose of inspecting those premises or any documents in them which appear to be relevant; or suspending the carrying on of any regulated activity by the RIE for a specified period.⁹⁸

3.224  The FCA also has the power to give a direction to the qualifying parent undertaking of an RIE if the FCA considers that this is desirable to advance one of its operational objectives. A qualifying parent undertaking is one which is incorporated or has its place of business in the UK, is not itself authorized or an RIE or recognized clearinghouse but is a financial institution.⁹⁹

3.225  If the FCA considers that an RIE has contravened a requirement imposed by the FCA under FSMA, or under any other provision of FSMA whose contravention constitutes an offence that the FCA has power to prosecute or by an EU provision specified by HM Treasury, it may publish a statement to that effect or impose a financial penalty of such amount as it considers appropriate.¹⁰⁰

3.226  If the FCA proposes to take such action, it must give the RIE a warning notice and, if it decides to proceed, a decision notice. If the FCA decides to do this, the RIE may refer the matter to the Tribunal.¹⁰¹

3.227  The policies and procedures the FCA will follow are set out in the Decision Procedure and Penalties manual (DEPP), part of the FCA Handbook. In determining what amount of penalty to impose, the FCA must include have regard to the seriousness of the contravention in question in relation to the nature of the requirement concerned and the extent to which that contravention was deliberate or reckless. In exercising, or deciding whether to exercise, its power in the case of any particular contravention, the FCA must have regard to any statement of policy in force at the time when the contravention occurred.¹⁰²

3.228  If the FCA considers that a qualifying parent undertaking of an RIE has contravened a direction given by the FCA or a provision of FCA rules, it may publish a statement censuring such person or impose a financial penalty on the parent undertaking or any (p. 162) person who was knowingly concerned in the contravention or publish a statement censuring the person. The procedures the FCA follows for these purposes are also set out in DEPP.

3.229  As noted earlier, an RIE must have satisfactory arrangements to investigate complaints from its members and others, both about the conduct of members and about the RIE itself. The FCA does not provide a mechanism for appeals about decisions made by the RIE but it is required to have arrangements to investigate complaints which are relevant to the question whether the RIE should remain as such.¹⁰³ That said, if the FCA receives a complaint about an RIE, it will usually encourage the complainant to exhaust the RIE’s own internal complaints handling process in the first instance.

3.230  The UK also has a regime for overseas investment exchanges. Given that FSMA prohibits a person from carrying on regulated activities in the UK, a person that wishes to do so has a number of options. They could become authorized by the FCA. If they are an EEA market operator, they could obtain exempt person status by exercising their passport rights in MiFID II. Alternatively, and once the UK leaves the EU, they could obtain exempt person status by being declared by the FCA to be a recognized overseas investment exchange (ROIE). Being an ROIE reduces the involvement which the UK authorities need to have in the day to day operation of the overseas person because they are able to rely substantially on the supervisory and regulatory arrangements in the country where their head office is based.¹⁰⁴

3.231  In order to become an ROIE, an overseas exchange needs to be able to demonstrate to the FCA that:

• •  investors are afforded protection equivalent to that which they would be afforded if the body concerned were required to comply with recognition requirements;

• •  there are adequate procedures for dealing with a person who is unable, or likely to become unable, to meet his obligations in respect of one or more market contracts connected with the investment exchange;

• •  the applicant is able and willing to co-operate with the FCA by the sharing of information and in other ways; and

• •  adequate arrangements exist for co-operation between the FCA and those responsible for the supervision of the applicant in the country in which the applicant’s head office is situated.

3.232  In considering whether it is satisfied as to these requirements, the FCA must have regard to the relevant law and practice of the country in which the applicant’s head office is situated and the rules and practices of the applicant.¹⁰⁵

(p. 163) 3.233  At least once a year, every overseas investment exchange must provide the FCA with a report containing a statement as to whether any events have occurred which are likely to affect the FCA’s assessment of whether it is satisfied as to the applicable recognition requirements. Chapter 6 of REC sets out the requirements applicable to ROIEs in further detail.¹⁰⁶

3.234  The approach the FCA has taken to implementation of the MiFID II requirements relating to MTFs and OTFs is arguably closer to the European requirements, with fewer additional requirements, than is the case with regulated markets. The main sets of rules applicable to MTFs are set out in Chapter 5 of the Market Conduct part of the FCA Handbook (MAR) and those applicable to OTFs are set out in Chapter 5AA of MAR. These largely copy or refer back to the relevant MiFID II and MiFIR provisions, but the FCA has added some commentary on certain points. In particular the FCA has provided helpful guidance on its interpretation of the activities of operating an MTF and an OTF in Chapter 13 of the Perimeter Guidance part of its Handbook (PERG).

3.235  That said, where an MTF or OTF is operated by an investment firm, a number of other parts of the FCA rules also apply in the same way they apply to other UK authorized firms. This includes some regimes which are not derived from European legislation such as the approved person regime which will be superseded by the extension of the senior managers and certification regime in December 2019.

3.236  Commodity futures and options contracts may be traded only on a board of trade that is registered with the Commodity Futures Trading Commission (CFTC) as a designated contract market (DCM) under the Commodity Exchange Act of 1936 (CEA). Historically, trading on DCMs took place in ‘pits’ located on the exchanges’ trading floors.

3.237  The process worked as follows: assume that an individual desired to enter into a futures contract in October 1999 that called for the delivery of 5,000 bushels of soybeans in March of the following year. The customer, unless he was himself a member of the exchange where the commodity was traded, would enter his order either directly or indirectly through a broker that was a member of the exchange and was registered with the CFTC as a futures commission merchant (FCM).

3.238  The FCM usually received the customer’s order by telephone and would write up the order and transmit it to the FCM’s booth on the floor of the exchange, typically by telephone or teletype. A clerk at the trading booth would then write down the order and hand it to a ‘runner’ who would in turn hand the order, or ‘flash’ it by hand signals, to a (p. 164) ‘floor broker’ standing in the trading pit on the exchange floor. The floor broker would then expose or auction off the order to the other individuals trading in the pit by a process referred to as ‘open outcry’.

3.239  The other individuals in the pit were floor brokers representing other customers and floor traders, or ‘locals’ as they are commonly called, who traded for their own account. The order would be auctioned off to the broker or floor trader with the best bid or offer. The completed order would then be reported back to the trading desk on the floor and a copy of the order would be thrown on the floor or at some designated place in the pit, to be later collected by exchange employees and entered into the books of the clearinghouse, a process that took a considerable amount of time.

3.240  The locals in the pits on the commodity futures exchanges quote a two-sided market. This means they were prepared to both buy and to sell the same commodity futures contracts. However, those prices were quoted at a ‘spread’ in which the bid is lower than the offer. This meant that, if there were no changes in commodity prices, a person who purchased a futures contract on the floor and then resold it would sustain a loss equal to that spread. Consequently, anyone entering orders on a commodity futures exchange had to pay the locals their spread. The locals justified this charge on the grounds that they were providing liquidity to traders and that they should be compensated for that service.

3.241  Open outcry trading on exchange trading floors was a laborious process. Hard copy order tickets were required to be filled in and time stamped by the FCMs upon receipt of a customer order. The order then had to be phoned, or teletyped, by the receiving broker directly to the floor, or through a trading desk, where additional hardcopy order tickets had to be filled in and time stamped. The open outcry system’s slow executions exposed traders to a market risk inherent in delays, from that ‘latency’. This is because latency creates a risk that market prices could change adversely between the time of order entry and execution. This risk is referred to as ‘slippage’. Slippage is one of the most significant costs to traders, along with the size of the bid-ask spread.

3.242  Floor trading presented other risks. Limit orders sometimes were not executed on the defendants’ trading floors during fast market conditions, allowing the market to trade through those orders. Floor brokers were sometimes slow in responding to bids and offers in crowded pits during the chaotic trading conditions that existed on many exchange floors during market moving events. Open outcry trading floors often resulted in errors and allowed abuses in the form of non-competitive trades, including wash trades and ‘bucketing’ of customer orders.¹⁰⁷

3.243  With open outcry trading, capacity constraints became a concern, particularly in large active markets experiencing volatility. In addition, floor trading could only occur in (p. 165) prescribed hours during the trading day or during ‘after hours’ sessions that were limited in length by the stamina of the floor traders. In recent decades, most floor trading has virtually ceased and has been replaced by electronic matching systems operated by DCMs.

3.244  The new electronic exchanges were mathematical models that were not subject to the vagaries, inefficiencies, and abuses found in the open outcry markets. In contrast to floor trading, electronic trading could occur twenty or more hours each day. A study also found that electronic trading had resulted in tighter spreads and more transparent pricing than open outcry trading.¹⁰⁸

3.245  High frequency traders (HFTs) on electronic trading platforms employ computer technology and algorithms that allow the origination, transmission, execution, and timing of their orders in times measured in fractions of a second, ‘a thousand times faster than you can blink your eyes’.¹⁰⁹

3.246  The matching role of electronic exchanges is carried out through algorithms that remove concerns over unfair treatment or abuse of orders on a trading floor. ‘In electronic systems, the algorithm that matches orders or trades constitutes the trading and execution rules that govern the priority and manner of trading. This leaves no room for disputes as to the applicability of the trading rules contained in the system . . . . This eliminates disputes about the validity of, or uncertainty as to the legality of, that interest.’¹¹⁰

3.247  The certainty of algorithmic matching also offsets the attractions of the liquidity provided by floor traders who had to be compensated in the form of wider spreads and inefficiencies in execution of orders. Concerns about whether trades had been properly executed in open outcry markets were greatly reduced through the algorithmic matching of orders in a computerized trading system. Electronic matching assured efficiency and proper execution of orders at a level that were unavailable on trading floors.

3.248  The governance structure of the commodity exchanges changed during the process of switching from open outcry to electronic trading. Formerly operated as membership organizations, the electronic exchanges have demutualized and become public companies. The commodity exchanges in the US have also consolidated and now fall under the umbrella of the CME Group or the Intercontinental Exchange (ICE). Electronic trading has not been free of detractors. Some traders seek competitive advantage over other competitors by co-locating their servers in exchange facilities and through the subscription of high-speed data feeds from the exchanges.

3.249  A vital part of the futures markets are clearinghouses that settle and guarantee the futures contracts that are traded on commodity futures exchanges. Commodity futures clearinghouses are required to register with the CFTC as Derivatives Clearing Organizations (DCOs).¹¹¹ The customer orders executed through an exchange trading platform must be represented by an FCM that is a clearing firm and which is a member of the clearinghouse. Clearing firms are large institutions that carry customer and proprietary positions with the clearinghouse. The clearing firms must guarantee their proprietary trades and the trades of their customers. Clearing firms may also have residual liability in the event that another clearing member fails and cannot meet its obligations or those of its customers. The clearinghouse guarantee is backed by the clearing firm members’ resources, margin requirements and a guaranty fund funded by transaction fees.

3.250  As one court noted, the clearinghouse ‘plays a vital role in assuring the financial integrity of futures transactions . . . . It becomes a party to every futures contract—“acting as buyer to every seller and seller to every buyer” As a party to each contract, [the clearinghouse] undertakes to guarantee the performance of its terms. In addition, it serves as a conduit for transfer of funds from each day’s trading activities.’¹¹²

3.251  The contract between the buyer and seller is executed in the name of their clearing firm through the exchange’s trading platform. Effectively, a novation occurs when the executed order is referred to the clearinghouse by the clearing firms. The clearinghouse then becomes both the buyer from the originating clearing firm representing the selling customer and the seller to the clearing firm representing the buyer. Importantly, these contracts are between the clearinghouse and the buyers/ sellers on the exchange.

3.252  Switzerland is one of the leading global hubs for commodities trading. It has developed over the years an ecosystem with all the required service providers for commodities trading houses, such as but not limited to, banks, universities, product testing firms, etc. There is in Switzerland so far only one important link in the service value chain missing. These are the trading venues on which commodities derivatives can be traded. Switzerland does not have a single trading venue that has commodities derivatives although it is home to EUREX, one of the most important derivatives trading venue worldwide. Switzerland’s vibrant structured products industry has however issued multiple structured products on commodities for investment purposes. There are, however, promising start-ups like Openmineral that facilitate the trading of physical base and precious metals between miners and smelters without an intermediary.

3.253  Securities (and financial instruments) can be traded in Switzerland on three main facilities, which are the Stock Exchange,¹¹³ multilateral trading facility (MTF),¹¹⁴ and the organized trading facility (OTF).¹¹⁵ Stock exchanges and MTF are also called trading venues and differentiate themselves mainly insofar that securities are only listed on a stock exchange. Securities are not listed on an MTF, meaning that there is no admission process of a security in accordance with a standardized procedure whereby certain requirements regarding issuer and securities are being verified.

3.254  The organizational requirements of all trading venues (MTF and Stock Exchange) are identical in their core and subject to their own regulatory and supervisory organization which is appropriate for their activities and approved by FINMA.¹¹⁶ Trading venues must ensure an adequate organization of the trading activities from a regulatory, technical, and organizational point of view that allows for pre- and post-trade transparency of bid and ask prices and related volumes.¹¹⁷ They have to appoint an independent body responsible for the regulation of the activities of the trading venue and the listing of securities in case of a stock exchange and the admission of securities in case of an MTF.¹¹⁸ Participants can either be securities dealers, foreign market participants, or other parties supervised by FINMA.¹¹⁹ The trading and compliance of the participants with the rules and regulations must be supervised by an independent body which has to inform FINMA in case of illicit activities and irregularities.¹²⁰ Certain admissions or delistings of securities and participants might be appealed with an independent appellate body.¹²¹ Trading venues must designate trading activities resulting from algorithmic trading activities. Participants engaging in algorithmic trading activities are also subject to specific requirements applicable to their systems.

3.255  An OTF is in Switzerland the default facility for other trading set-ups encompassing bilateral and multilateral as well as discretionary and non-discretionary trading activities in both securities and financial instruments, meaning any other financial instruments used for investment purposes not being securities.¹²² Although the term ‘financial instrument’ is to be understood broadly, it does not include precious metals and other commodities spot-transactions.¹²³ The sale of financial instruments such as structured products is not covered under the OTF regime if specifically created for a client by the party that created them and if no repurchase (p. 168) prices are provided by the seller or in the seller’s system during the duration of the products (e.g. structured products that cannot be resold to the issuer). A trading activity on an OTF is any trading activity that:¹²⁴

• •  is governed by a set of rules that is standardized and binding to participants;

• •  allows for the conclusion of contracts within the scope of application of these rules; and

• •  where the initiative to trade can come from any participant.

3.256  An OTF can only be operated by a duly licensed bank, securities dealer, trading venue, facility recognized as a trading venue, or a legal entity within a financial group that is controlled directly by a financial market infrastructure and is subject to consolidated FINMA supervision.¹²⁵ Unlike under MiFID II/MiFIR, a systematic internaliser is under the Swiss regime not a special category of investment firm/securities dealer, but is either a bilateral OTF or securities dealer if these requirements are met.

3.257  The operation of an OTF is also subject to requirements that ensure orderly trading, transparency, and investor protection, such as best execution requirements in case of discretionary trading.¹²⁶ Any operator of an OTF must issue rules and regulations and appoint an independent control function that monitors compliance with these regulations.¹²⁷ Pre-trade transparency is required in case of bilateral and multilateral liquid trading, meaning at least 100 trades on average per day over the last year. Post-trade transparency is only required in case of multilateral trading. Anyone operating an OTF or intending to do so in the future must report this fact to FINMA.¹²⁸

3.258  The Monetary Authority of Singapore (MAS) currently regulates market operators under two categories, namely the approved exchanges (AEs) and the recognized market operators (RMOs).¹²⁹ As of June 2018, there are three AEs operating in Singapore comprising the Singapore Exchange (SGX), ICE, and Singapore’s third and latest exchange derivative exchange, Asia Pacific Exchange (Apex). In addition, there are thirty-six RMOs, which includes players like Cleartrade for trading commodity derivatives and Bloomberg Tradebook and BGC for bond portals.

3.259  AEs are usually subjected to higher level of statutory obligations as they are important market operators. At present, only AEs are allowed to serve the retail investors. With the emerging of new trading platforms and technology, regulators are looking into new perspective and flexibility for where investor’s interests are safeguarded.