Shall we compare thee to a multilateral trading venue?

As William Shakespeare never quite put it: “What’s in a name? That which we call a trading venue by any other name would smell just as sweet.”

Yet for software firms that operate aggregators and for execution management systems (EMSs) that organize trading orders and assist with execution, there is a great deal in the name that EU and UK regulators might use to designate their activities.

The European Securities and Markets Authority and the UK’s Financial Conduct Authority this year closed a chapter in the long-running debate over whether software vendors fall within the reach of trading venue legislation—and whether these firms should be designated as trading venues and have to change their entire business models as a result.

Experts agree that the most recent guidance—published in February by Esma and in July by the FCA—is likely to be the regulators’ last word for some time. Nevertheless, questions remain over how the two bodies will enforce the rules, especially for the software firms and EMSs that are affected.

Esma stated that any platform bringing together multiple buyers and sellers that might interact with each other could be defined as a “multilateral system”, though it acknowledged that there was no consistent view about what would constitute such a system. Its view was echoed by the FCA, which wrote that a system’s features, rather than the language it used to describe itself, would determine whether it should be regulated.

Firms that are not licensed as venues have, in the past, argued that they serve as software providers, not trading venues, and thereby fell into a gray area that allowed them to operate outside the regulatory perimeter. Some of these ‘middleware’ firms aggregate prices from dealers and regulated multilateral trading facilities. However, they maintain that trading is conducted on a request-for-quote (RFQ) basis and have described their platforms as a solution that users can draw on to create their own MTFs. They also insist that they do not run these platforms themselves.

The regulators’ assessments amount to a victory of sorts for regulated venues, which argued for years that they had to compete unfairly with technology vendors operating venue-like systems without licensing. Regulated venues claim this has allowed tech vendors to offer services similar to their own but at significantly lower costs.

As the dust settles, technology providers without trading venue licensing are left to pick through the guidance to determine whether their current offerings mean they qualify as regulated venues. Esma’s guidance is already in force, but the FCA has given firms until early October before its own guidance applies.

The FCA and Esma are both pretty clear that the age of the unauthorized RFQ service is over. If you have an RFQ system, you have to start from the assumption that you’re caught

London-based lawyer

“Some are still planning to take a risk-based approach,” says Raza Naeem, partner at law firm Linklaters. “Others are exploring what setting up an MTF could look like. Some others are looking at how they can tweak their functionalities to potentially avoid falling foul of all of this.” Naeem says the last option may be the most appealing to firms without any type of existing financial regulatory permissions, given the effort involved in going through all the processes before authorized status can be granted.

The EU and UK guidance may hit foreign exchange derivatives vendors the hardest—largely because trading takes places bilaterally through application programming interfaces, either directly with dealers or through aggregators.

A London-based lawyer who advises technology providers says the direction of travel had been clear, but that the most recent FCA guidance had elicited a forlorn response from certain clients.

“Resignation is probably the best word to describe the reaction to this,” says the lawyer. “It’s been telegraphed for a while that something like this was coming, so it’s not entirely a surprise.”

Two households both alike in dignity

Esma and the FCA based their assessments on the same regulations: the second Markets in Financial Instruments Directive (Mifid II) and the Markets in Financial Instruments Regulation (Mifir), both of which have been incorporated into UK law following Brexit. Intended, in part, to increase transparency by bringing more trading on to regulated venues, the rules stipulate that platforms meeting the newly introduced definition of multilateral systems should be authorized as trading venues.

To qualify as a multilateral system, a platform must have the characteristics of a system or facility, bring together third-party buying and selling interests, and allow trading interests to interact. Only trading interests in Mifid-qualifying financial instruments, such as derivatives, qualify—which means products such as spot foreign exchange are excluded.

In its final guidance, the FCA noted that technological development since Mifid and Mifir came into force in 2018 had led to uncertainty over what constituted a trading venue: “The evolution of the definition of a multilateral system and technological developments have made it more challenging to distinguish certain types of arrangements and systems from trading venues.”

There aren’t nice, clear blanket exclusions. Everybody needs to go through that analysis, whether they see themselves as a software provider or whether they already operate trading venues

Hannah Meakin, Norton Rose Fulbright

One area of potential ambiguity involved systems aggregating over-the-counter (OTC) trading facility liquidity and allowing users to request quotes from liquidity providers individually. Both Esma and the FCA said this RFQ-to-one functionality would not, in and of itself, exempt a firm from needing to be regulated if users could potentially interact with multiple parties when they entered its system.

“The FCA and Esma are both pretty clear that the age of the unauthorized RFQ service is over,” says the London-based lawyer. “If you have an RFQ system, you have to start from the assumption that you’re caught. You also have to come up with some pretty compelling arguments about why your RFQ system is not itself a multilateral system, and hence not a trading venue.”

Regulators note that not all technology providers engaged in venue-adjacent activities have to seek licensing. Services that only broadcast trading interests—so-called bulletin boards—can safely operate outside the perimeter provided users are unable to interact within the system. Platforms that only facilitate communication are also exempt. Even a system that meets all the requirements of a trading venue can avoid the need for authorization if the platform ensures that all facilitated transactions reach a regulated venue.

There is also the issue of single dealer platforms. In the past, this model has been accepted as not being multilateral because all users transact with the same counterparty, so there is no chance of multiple buyers interacting with multiple sellers. However, Esma stated that a single dealer platform could amount to a multilateral venue if a third party set the platform’s rules and was seen to be controlling interactions. The FCA did not make a similar statement.

Hannah Meakin, partner at law firm Norton Rose Fulbright, says that characterizing the existing regulated venues as the winners of the multi-year debate—and the disruptive technology providers as the losers—oversimplifies the impact of the FCA’s guidance.

“Some of the biggest groups that operate exchanges will still have functionalities in systems where they’ll be thinking about the same types of issues that a tech company would need to think about,” she says. “There aren’t nice, clear blanket exclusions. Everybody needs to go through that analysis, whether they see themselves as a software provider or whether they already operate trading venues.”

Meakin adds that the UK regulator’s explanations served more to remind market participants of the requirements than to clarify any vagueness, “I’m not sure there were necessarily ambiguities in the first place, but maybe there were areas [where] the market had settled into an understanding of how they perceived the FCA was interpreting the definition. People had started to gain an understanding of what a multilateral system was based on who was regulated as such.”

Elias Allahyari, an associate at law firm Shearman & Sterling, takes a similar view. “This isn’t necessarily extending the perimeter, but rather firming it up,” he says. “These boundaries have always existed—there’s simply been various arguments of how malleable the definitions are.”

Meakin adds that firms will also have to continually reassess whether additional features bring their systems within the scope of the regulation.

Previously regulated venues are nevertheless satisfied with the outcome of Esma’s and the FCA’s consultations, which they regard as an important step towards leveling what they see as an unfair playing field.

“They feel relatively confident that the regulators have listened to them,” says an industry expert familiar with the thinking at several trading venues. “They’ve been talking about this for four years, probably. It’s as good a place as they can possibly get it.”

Confusion now hath made his masterpiece

Experts say that order and execution management systems remain a significant gray area in terms of regulation. The software, which is designed to automate and centralize trade orders and facilitate execution by aggregating prices from execution venues, is a staple of buy-side execution desks.

Both Esma and the FCA underscored the need to make assessments on a case-by-case basis, but left open the possibility that firms advertising themselves as technology providers would need to seek authorization for their management systems.

Esma stated, “An EMS which would allow for firms to gather quotes from multiple players, allowing these trading interests to interact within the system with other clients’ orders could be, depending on the specifics, a multilateral system and subject to the authorization as a trading venue.”

Tim Cant, partner at law firm Ashurst, says this could lead to significant change in the industry. At issue are the integrations with OTC price streams and execution facilities, since only routing orders to regulated venues would exclude a system from having to be regulated.

“It could effectively mean these EMSs will turn OTC price feeds off and just go to the trading venue feeds,” he says.

Cant says he is working with various EMS providers, some of which he believes will apply to the FCA to become trading venues. However, he thinks smaller firms may try to operate under the radar—for example, by shutting off non-venue trading feeds.

[Established venues] feel relatively confident that the regulators have listened to them. They’ve been talking about this for four years, probably. It’s as good a place as they can possibly get it

Industry expert familiar with the thinking at several trading venues

To meet the definition of a multilateral system, an EMS would have to allow buying and selling interests to interact, even if execution did not take place within the system. Market participants had previously seen execution as a distinguishing feature between trading venues and assistive software services. If execution occurred on the platform, it was more likely to be a trading venue; without execution, a service could consider itself exempt.

However, with their latest guidance, Esma and the FCA extinguished any lasting belief that firms could continue to make this argument. The regulators stated that multilateral facilities involve interaction between participants, and that concluding a contract outside the system does not remove the need to seek authorization. Interaction can mean matching buy and sell interests, or allowing users to request, accept and negotiate the terms of a transaction.

Yet there would still need to be rules in place to govern these interactions before regulators could consider a platform a multilateral system.

Seemingly basic settings, such as the order in which quotes appear—arranged by price, size or counterparty—could constitute rules, and who adjusts the rules could determine whether a system is multilateral.

Rule setting could bring single-dealer platforms into scope if a third-party became involved. However, if the platform set its own rules and acted in a similar manner to a systematic internalizer, it would not be considered a multilateral venue.

The question is how regulators will enforce the guidance now that they feel market participants have been adequately briefed on the guidance. Experts say that, like other rules governing financial markets, the guidance remains broad enough to give regulators the flexibility to adapt to evolving technology.

What country, friends, is this?

Esma delegates enforcement to national competent authorities. It is unclear how many resources Esma, national authorities and the FCA will dedicate to the issue, which will most likely be interpreted on a case-by-case basis.

“The problem that this type of perimeter issue has, and the reason why we’ve been discussing it for such a long time, is because even though there was guidance, nobody actually took any action,” says Diego Ballon Ossio, partner at Clifford Chance. “We now need the corresponding enforcement action to provide more clarity.”

Nevertheless, the guidance may result in significant changes to tech vendors and their business models. Firms will have to hire compliance specialists to ensure their services do not breach the rules, thereby adding another layer of overhead costs.

A more severe impact could be vendors no longer allowing clients to use their software to access bilateral liquidity, as that would risk bringing them under the scope of the rules.

Steven Burrows, director of financial markets and products at law firm Fieldfisher, says technology providers will have to distance themselves from how clients use their products if they want to avoid having to register as trading venues.

“If technology firms really want to steer clear, the business model might have to change,” he says. “They have to take much more of an arm’s length approach—hand over some software, provide periodic support or updates to it, but not actually get involved in any operations.”

The challenge will be how the barrier is developed between trading venues that will need to become regulated and those that can continue as software vendors. The latter will need to adapt their way of working and their relationships with clients if they do not want to be captured by the guidance.

Otherwise, firms will have to get ready for the responsibilities involved in becoming regulated venues. In both the EU and the UK, the status comes with regulatory and liquidity capital requirements and anti-money laundering and financial crime prevention procedures.

“Fundamentally you’re being authorized to operate a piece of market infrastructure,” says Burrows. “And for the FCA, there’s no delineation between a very small exchange that only does a limited range of products and something more systemic in nature. The scope of regulation is broadly the same.”

To adapt or not to adapt—for software providers, at least, that is the question.

Contributing reporting by Natasha Rega-Jones