Post-Brexit, the Financial Conduct Authority (FCA) and the European Securities and Markets Authority (ESMA) appear to be diverging in their views on the operation of frequent batch auctions (FBAs) within the MiFIR/MiFID II equity markets pre-trade transparency regime. ESMA takes the view that certain aspects of the functioning of such auctions should require them to operate under a pre-trade transparency waiver but the FCA has no plans to change the operation of the current regime.
Users of such auctions favour FBAs because they limit the influence of high frequency trading and contribute to a better trading environment. They may therefore favour FCA-regulated venues, if this divergence of approach manifests in future regulatory tightening in the EU. This is particularly the case in the context of the double volume cap mechanism.
ESMA has expressed concerns that, as in the case of broker crossing networks, frequent batch auctions are being used to avoid the double volume cap mechanism (DVC). In its MiFID II/ MiFIR review report on the equity transparency regime ESMA affirmed its intention to separate the descriptions of conventional periodic auctions and FBAs, and to develop a tailored definition for FBAs.
Conversely, in its paper on periodic auctions, the FCA said the terms "frequent batch auction" and "periodic auction" were interchangeable. In its recent paper on dark trading bans, however, it concluded that reductions in transaction costs occurred from trading in alternative venues — such as periodic auctions — when dark trading was banned.
ESMA has issued a call for evidence, final report and opinion on FBAs in the context of the DVC. The MiFID ll/ MiFIR review report, as noted above, also addressed the issue. ESMA has also recognised that FBAs started to gain market share after the DVC ban. In terms of regulatory requirements, ESMA said that most FBAs applied the pre-trade transparency requirements for ostensibly "lit" periodic auction trading systems located in Annex 1 of MiFIR RTS 1, rather than a dark pool waiver.
RTS 1 provides (somewhat tautologically) that a periodic auction trading system is a system that matches orders on the basis of a periodic auction and a trading algorithm operated without human intervention. The information to be made public is specified to be the price at which the auction trading system would best satisfy its trading algorithm and the volume that would potentially be executable at that price.
Central limit order books
Proponents of FBAs maintain that they address flaws in the continuous limit order book (CLOB). The FCA, in its paper on periodic auctions, explained that the main difference between periodic auctions and CLOBs, the most common format for share trading, is that that CLOBs are continuous. This means that if a trading firm sends a buy order to a CLOB and there is a matching sell order resting on the order book, the trade will execute instantly in accordance with the time at which the order is received. In a periodic auction, the firm has to wait until the end of the call period. Given the speed of modern share trading, however, that wait may be only 100 milliseconds.
The flaws in CLOB systems are characterised thus: "In a CLOB, if a firm's order arrives after that of another market participant, even by only one nanosecond, then that other order will be ahead in the queue. This can result in the later trade not being executed, or getting a worse price. In periodic auctions, these tiny time differences matter much less. This means that market participants who do not have access to superfast trading technology (for example, servers located in the same building as those of the exchange operator, direct fibre optic or microwave connections between different trading locations) are less at risk of losing out to those who do."
Frequent batch auctions and conventional auction systems
ESMA defines FBAs as systems of a very short duration taking place at certain points in time during the course of the trading day which are triggered by the market participants. It says that orders are aggregated before and during the auction call without leading to a trade and — at a specific point in time — they are matched and executed at a single price. In ESMA's view, Annex I of RTS 1 is a measure from the MiFID l era and did not address regulatory issues raised by the operation of FBAs. ESMA contrasts FBAs with "conventional auction systems" or "opening and closing auctions" addressed in RTS 1.
These do contribute to the price-forming process because the orders are aggregated before and during the auction call without leading to a trade and — at a specified point in time — buy and sell orders are matched and executed at a single equilibrium price. As noted above, the FCA's view is that "frequent batch auction" and "periodic auction" are interchangeable terms.
FBAs and pre-trade transparency
ESMA considers that the requirements in RTS 1 are insufficiently clear in the case of FBAs where an auction call is initiated upon the receipt of the first order, but pending a potential match. It said that most of these systems do not publish any pre-trade transparency information pending a potential match and investors are not sufficiently informed of the true level of potential trading opportunities.
It has concluded that trading venues operating FBAs should inform market participants that an auction had started, thereby making market participants aware that there might be a trading opportunity and enabling them to participate in the auction. This, ESMA said, should be based on the pre-trade transparency requirements of indicative price and volume as specified in Annex I of RTS 1.
It noted in the final report that the disclosure of such information should allow other market participants to participate in the auction while at the same time not disclosing too much information, thereby addressing concerns about excessive pre-trade transparency leading to information leakage. A similar concern regarding information leakage was expressed in ESMA's MiFID ll /MiFIR review report.
FBAs and price determination
ESMA's opinion sets out several practices which, in its view, may undermine the price formation process, and details three functionalities which would result in non-price-forming FBA systems. These are systems that allow only for the submission of pegged orders and/or adjusted limit orders; the use of price band limitations and systems that lock in the prices at the beginning of an auction. It notes that, under two pre-transparency waivers, clearly specified circumstances — such as orders based on a reference price trading methodology and negotiated transactions in liquid instruments — certain orders/transactions may not need to be made pre-trade transparent and can operate as dark pools.
One reason is that such orders do not contribute to the price formation process. ESMA's proposal is that periodic auction systems, including FBA systems, could operate as non-price-forming systems and could benefit from a pre-trade transparency waiver; in particular the reference price waiver (RPW) and the negotiated trade waiver (NTW). This could mean that they would be subject to the DVC.
The first category, it suggests, is systems that allow only for the submission of pegged orders and/or "adjusted limit orders", i.e., orders that reference to a price from other systems and/or limit orders that are automatically adjusted to be within the limits of the best bid and offer (BBO), aimed at ensuring all transactions will be either executed at mid-point and, in any case, within the BBO at the time of submitting the order.
The second functionality it describes is systems that allow for the use of price band limitations referring to prices determined by other systems, ensuring that the uncrossing price is always within the European best bid and offer (EBBO) or the primary best bid and offer (PBBO).
The EBBO is a composite of the best prices available for buying or selling a stock from a selected number of European trading venues. The PBBO is the best price available for buying or selling a stock from an individual European primary trading venue.
ESMA considers that FBA systems using price band limitations referring to the EBBO or PBBO do not, however, meet the MiFIR conditions for granting a reference price waiver. This is because — according to art 4(1) of MiFIR — the reference price should be derived from a single trading venue, whereas the current price band limitations of FBA systems rely on reference prices from various trading venues to determine the EBBO/PBBO.
Furthermore, according to art 4(2) of MiFIR, ESMA says, the reference price should be either the mid-point or the opening or closing price where the mid-point is not available. A price collar referring to the EBBO/PBBO does not meet the conditions in art 4(2) of MiFIR in its view.
The third functionality specified in the opinion as being non-price-forming is one that locks in the prices at the beginning of an auction, where the locked-in price does not follow the submission of unadjusted limit orders. ESMA considers that systems that lock in the price at the beginning of an auction where the price is determined based on unadjusted limit orders are price-forming systems. Systems that lock in prices based on other conditions are non-price-forming in its view and should, in principle, operate under a waiver from pre-trade transparency.
Transactions not systems
In the MiFID ll/MiFIR review report ESMA proposed that — since the objective of pre-trade transparency consists in ensuring an efficient price-formation process — non-price-forming systems should only be authorised to operate under a waiver from pre-trade transparency.
ESMA neverthelss said it shared the view expressed by many stakeholders that the concept of non-price-forming systems/transactions needed further elaboration. It considered that an approach focussing on specifying non-price-forming transactions might be more practicable than defining non-price-forming systems.
ESMA therefore suggested complementing art 4 of MiFIR by requiring that trading models executing non-price-forming transactions should only be operated under one of the waivers specified in art 4(1) of MiFIR. It also recommended adding a Level 2 mandate empowering it to specify the types of non-price-forming transactions.
To ensure a consistent approach toward non-price-forming transactions, and being mindful that RTS 1 already provides for three lists of non-price-forming transactions (under arts 4(1)(b), 20 and 23 of MiFIR), ESMA recommended streamlining those lists.
It suggested that one list could cover technical transactions — those where the price is not determined directly by the market — and another could cover price-taking transactions. Transactions on both lists would be considered non-price-forming and could only be executed under a waiver from pre-trade transparency.
In the MiFID ll/MiFIR review report ESMA said that, after careful reflection of the feedback provided, it maintained its proposal to separate the descriptions of conventional periodic auctions and FBA systems, to better tailor the applicable pre-trade transparency requirements.
It therefore intended to develop a tailored definition for FBA systems in RTS 1 when the standard was next reviewed. It did, however, take note of the concerns raised by some stakeholders on the proposal to require the disclosure of all orders, and said it would further reflect on the appropriate pre-trade transparency regime for FBA systems. Possible future proposals to amend RTS 1 would be subject to public consultation.
In its research paper on periodic auctions the FCA said it was carrying out further analysis of the equity trading landscape as a whole, including the design, calibration and use of periodic auctions within that landscape, and said it would publish further analysis of those issues. In its supervisory statement on MiFID at the end of the transition period the FCA recognised that, since the implementation of MiFID ll, FBAs had grown in significance.
It took the view, however, that it did not believe non-price-forming auctions needed to operate under a waiver from pre-trade transparency where they published price and potential executable volume. ESMA, as noted above, considers that non-price-forming systems should only be authorised to operate under a waiver from pre-trade transparency.
The FCA also said in its statement that it did not believe auctions with price band limitations were constrained to use a price benchmark from a single trading venue which was either the trading venue in the UK where the instrument was first admitted to trading or the most relevant market in terms of liquidity. Transactions executed off-tick at the mid-price were permissible when required by the auction algorithm used by the FBA, it said.
ESMA, however, considers that the use of price band limitations is a functionality which would result in a non-price-forming FBA system. Unlike ESMA, however, the FCA has no current plans to change the application of the equity market pre-trade transparency regime.