Industry experts are predicting that the UK Financial Conduct Authority will diverge from its European counterpart’s definition of a trading venue, potentially creating a confusing regulatory landscape on the continent for a cohort of vendors that could be dragged into scope and forced to register as venues.

The FCA is set to publish a consultation paper on September 22 that will prompt industry discussion about whether to extend the definition of a trading venue. Similar debates are taking place across the European Union and the United States. The FCA paper was due to be released on September 16, but the date was pushed back, in observation of the mourning period for the death of Elizabeth II.

Sources say that because the FCA is looking to establish itself as a competitive market on an international stage, its review of the trading venue perimeter will not be as far-reaching and should not envelop as many vendors as the European Securities and Markets Authority (Esma). But not aligning with the EU could create a confusing and disjointed compliance landscape.

Suppose the UK takes a different stance from the EU, its closest market and trading partner. In a post-Brexit world, this could mean that vendors, which are not deemed venues in the UK but need to be registered as venues in the European Union, will have to establish separate entities and offices on UK and EU soil.

Stephane Malrait, global head of market structure at ING Bank, says UK vendors that service the EU market and are expected to fall into the scope of Esma’s definition will have to contend not only with the legal burden of registering as an EU entity, but will also face a long list of logistical costs. Among those include acquiring a new office, filling it with newly hired personnel, and establishing a compliance team responsible for monitoring and reporting activities. In addition to that are the tech challenges and the siloed frameworks around those IT stacks.

“This is quite a big job to do,” Malrait says. “There is also a technology change because the regulation is not going to be the same on both sides, and if you end up with two legal entities—or one legal entity on one side and not on the other—you cannot have a mixed tech stack. They must be run separately from a technology point of view.”

In this case, even if a provider’s underlying technology is the same, it will have to have a separate set of functions and governance structures to operate across the varying UK and EU regimes.

“It is more than just a legal challenge—it’s a technology challenge,” Malrait adds.

On mainland Europe, as part of its regulatory review of Mifid II, EU regulators are consulting on their own definition of a venue. In late January, Esma published its opinion on what constitutes a multilateral system and trading venue—thus mapping out which firms would need to seek authorization. Many banks and industry firms voiced concerns that Esma’s current definition is too broad and captures a swath of vendors, including execution management systems (EMSs), workflow platforms, chat applications, request-for-quote systems, and more. Some knock-on effects of a broad interpretation are that it could stifle innovation or inflate the cost of trading.

For instance, if more intermediary trading vendors are expected to register as venues, those new overheads could be passed on to buy-side firms and investors. Esma’s final report is scheduled to be released before October 1, 2022. The EU regulator was contacted for an exact date on when the report would be published, it said before the end of the year.

Six sources spoken to for this article anticipate that the FCA will take a mild approach to broadening the regulatory scope of a venue. This is because of its ambitions to make the UK a more competitive market, which can be seen in its favored approach to roll back on shored EU rules post-Brexit, like the scrapping of payment for research and best execution requirements (RTS 27 and RTS 28) under Mifid II.

Others believe the UK will also deviate from the EU’s trading venue definition due to the way the FCA operates as a regulator.

“The FCA consultation may not go as far in terms of detail as Esma’s paper because the EU is more rules-based and its regulation can be more prescriptive, versus the UK’s approach, which is more principles focused. It allows for market adjustments and greater competition,” says Jennifer Keser, head of regulation and market structure at Tradeweb.

One senior executive at a London-based data and tech vendor, with a strong understanding of the FCA’s wholesale markets review plans, says the regulator is better at engaging with the industry than its EU counterpart.

“The FCA is much more open to learning some of the industry’s concerns and they do that on a much more engaged basis. Whereas Esma has a tendency just to put out the consultation paper, get some feedback, but then do what they want anyway,” says the executive.

A spokesperson for Esma says the regulator “is committed to transparency and cooperation and works to ensure strong stakeholder engagement with entities and individuals impacted by our activities.”

Upon initial glance, the FCA taking a lighter approach to regulation should be positive for the vendor community and investment firms that use them. Yet some worry that any divergence between rulebooks on the continent is bad news for investors and ultimately leads to pricey overheads.

“Regulatory divergences are not in anyone’s best interest. They create complexity and increase costs for the industry,” says Hayley McDowell, an equities sales trader at RBC in London and market structure consultant.

She adds another potential consequence of divergence is that it could create an unlevel playing field for EU domiciled vendors or UK-based firms hoping to continue servicing the EU markets.

“If EU firms have a greater obligation and burden to offer their services, ultimately that will lead to less competition, innovation, and deter investment in the European markets,” McDowell says.

So why is this happening?

The European Commission is engaged in a wide-ranging review of Mifid II that began in early 2020. In one part of the rework efforts, Esma launched a consultation on the functioning of an organized trading venue and a multilateral trading facility (MTF). This was followed by its opinion on what constitutes a multilateral system at the beginning of the year.

In it, Esma says a multilateral system is a system or facility where multiple third-party buying and selling interests of financial instruments can interact.

The debate on the definition arose due to heavy lobbying from regulated MTFs, such as MarketAxess, Tradeweb, and Bloomberg. The market operators argue that a cohort of tech firms are eating into their businesses by mimicking trading venues without authorized licenses. Again, examples range from front-office trading systems to RFQ platforms.

“One concern that we have had with the emergence of these new unregulated systems is those market participants who use them might be under the impression that they stand to have the same benefits as when they’re trading on regulated venues, and that’s not the case,” Tradeweb’s Keser says.

On the flip side, many of these vendors dispute that they don’t fall into the scope of Esma’s current opinion or argue that the definition is overreaching. And while the industry has yet to see the final draft from Esma, many feel the regulator has already made up its mind.

Back in March, Andrew Mahoney, managing director at FlexTrade, an EMS provider, said: “It feels like the end. It doesn’t feel like this is a consultation paper. It feels very much like they are saying, ‘Enough of the discourse—this is what’s going to happen.”

Another senior executive at a second EMS provider similarly says there is a feeling of inevitability that many execution systems will have to be regulated. But despite the burden, their firm is willing to absorb the costs.

“Bilateral trading is here to stay whatever regulatory obstacle that comes into play—albeit at an additional cost to the EMS vendors. The buy side wants it and the sell side needs it, and trading venues don’t have the right solution to support bilateral trading yet,” the senior executive says.

Enforcement

Once the final drafts have been released and the amended rules come into force, the next big question to be hashed out is, how will this be enforced? Several sources suspect that Esma will take the prescriptive approach, meaning it will need to provide a lot of detail to avoid any misinterpretation from any of the EU 27 nations and their national competent authorities.

“If Esma is to take the lead here, they will need to provide more guidance, become more prescriptive, and assume the role of defining the trading venue perimeter,” Malrait says.

The FCA, on the other hand, has the benefit of overseeing one market and one legal system, and could, therefore, more easily enforce any new rules based on a case-by-case approach.

Malrait adds that, in their final consultation papers, both regulators should also look at the trading venue perimeter through the lens of each asset class to account for their different trading needs and nuances.

“If you look at that definition from an equity angle, you may end up destroying something for the FX products. Or if you only look at it from an FX view, it may have a negative impact on the fixed income side, or the commodity side, or other asset classes,” he says. “So I hope they will include those dimensions to explain the differences: what are the impacts on different asset types, and how technology is used in those different asset classes. That’s one dimension that we didn’t see in the European consultation that could be answered on the UK side.”

One trading head at a regulated venue says that what the FCA and Esma are trying to achieve is not trivial when trying to satisfy the two sides of the heated debate: the venues versus the cohort of vendors, the sell side and the buy side.

“The UK—and indeed the EU—want to ensure that they are striking the balance between protecting market participants on one hand, and on the other hand, persisting innovation in the fintech space.” says the trading venue head.

“I recognize it’s a very hard balance to strike.”