At a glance:

  • HM Treasury (HMT)’s wholesale markets review sets out a wide range of potential reforms to the UK’s capital markets regulation and could be considered the UK’s “MIFID III”.
  • HMT wants the UK to be “an open and global financial hub” and this review is intended “to cement the UK’s position as a global hub for wholesale markets.”
  • If the review’s reforms are adopted then we expect the UK’s wholesale markets to operate under a less prescriptive regime than at present, and one which will give market participants greater freedom in how they execute trades and may in time lead to a broader range of execution venues flourishing.
  • Time will tell whether the reforms can contribute to the objective of broadening and deepening the UK’s capital markets. But HMT’s clear intent is to sweep away any regulatory impediments to this happening.
  • The EU is also undertaking its own review of MiFID II/MiFIR and will set out legislative proposals in Q4 2021/Q1 2022.
  • Even where the EU and UK are agreed that they will make changes to the same part of the current MiFID framework, in many cases they have put forward differing reforms. This may ultimately drive further divergence between the respective regimes, even when a common problem is identified.
  • The UK has moved swiftly in setting out these reforms and we expect the EU’s political process to mean it will take longer to secure any changes. This should mean the UK can make its proposed changes more quickly, giving the UK a first mover advantage.

Introduction

HMT recently published its wholesale markets review consultation, setting out a wide range of potential reforms to the UK’s capital markets regulation.

Our final blog in our previous series on regulatory divergence set out how the UK was beginning to diverge from the EU’s wholesale markets regulation and how the FCA had fired the starting gun on regulatory reform with its consultation paper (CP21/19) on “Changes to UK MiFID’s conduct and organisational requirements.” The publication of HMT’s review marks the next step in the UK reforming its wholesale markets.

This blog sets out HMT’s vision for UK wholesale markets, and analyses the key policy reforms put forward in HMT’s review and how the UK’s reforms compare with the EU’s potential revisions to MiFID II/MiFIR, on which we expect to see proposals later this year or early next.

The review is open for responses until 24th September 2021.

HMT’s vision for UK wholesale markets

Now that the UK has left the EU, the UK Government has committed to revisit various parts of the on-shored EU financial services regime in order to ensure these regulations are better tailored to the needs of the UK.

The EU has also committed to build its own Capital Markets Union and secure “strategic autonomy” for its financial services sector. This has led to a concerted effort to shift euro‑denominated and EU listed financial services activity into the EU and away from the UK. The EU has seen some success, with some capital markets activity shifting to the EU following Brexit. It is against this background that the UK is looking to maintain and enhance its global reputation as a capital markets hub.

A key aim of the Government’s financial services strategy is to make the UK “an open and global financial hub” with world leading financial markets. HMT’s wholesale markets review is a key component of this strategy, intended “to cement the UK’s position as a global hub for wholesale markets.”

The review aims to uphold high regulatory standards, promote the openness and competitiveness of UK markets, and ensure the UK’s wholesale markets regulation is less prescriptive and more proportionate. It also wants regulation to support the UK’s economic growth.

In line with the financial services strategy’s commitment to making the UK “a world leader in green finance” and “at the forefront of technology and innovation”, the review poses several broad, open‑ended questions relating to technological innovation and the move to a low carbon economy and green finance. Unlike other areas of the review, HMT’s thinking on these matters seems less developed, suggesting that while HMT remains committed to these parts of its vision, it is looking to firms to help shape its approach and flesh out some of the detail.

Many of the review’s more specific reforms look to bolster the competitiveness of the UK as a trading hub, giving more firms more flexibility over where and how they trade by removing various constraints. There are also proposals to give trading venues greater discretion over how they operate, and on what the appropriate regulatory perimeter for some of these firms should be. More generally there is a desire to review what parts of MiFID II have worked well, and to remove or reform those aspects of the regime which either place an undue burden on firms, or simply don’t deliver their intended outcomes. All of this underpins HMT’s desire to have a financial system in which firms can compete with one another on a level playing field, which should in turn drive better outcomes for end investors who will benefit from an innovative and open wholesale marketplace.

Time will tell how much the package of regulatory changes set out here can contribute to achieving these aims and ultimately broaden and deepen the UK’s capital markets. But HMT’s clear intent is to sweep away any regulatory impediments to this happening.

What aspects of the UK wholesale markets regulatory regime is HMT looking to reform?

HMT’s wholesale markets review poses 105 different questions. Some of these ask about specific changes. Others are more open‑ended and give more room for respondents to shape HMT’s thinking. The questions cover everything from trading venues and the Systematic Internaliser (SI) regime, through to transparency requirements, commodity markets, SME finance, reporting requirements, market data and much broader questions around what can be done to support technological innovation and the move to a low carbon economy.

Share Trading Obligation (STO) and double volume cap: As the Chancellor had previously flagged, the consultation asks whether both the STO and the double volume cap should be removed from the UK’s MiFID framework. HMT is minded to remove these rules in order to broaden the range of execution venues available to UK traders and their clients, and facilitate best execution. UK regulators are of the view that these rules add extra costs and complexity without improving outcomes for end investors.

Best execution related reforms: Other proposals in the review also seek to improve best execution and firms’ ability to achieve the best price for investors. These include asking whether SIs should be able to execute trades at the mid-point price, some post-trade transparency deferrals for non-equity trades should be removed (to improve price formation), and whether OTFs should be able to execute transactions relating to packages of derivatives that include cash equity products.

Commodity position limits: As expected, the consultation also asks whether the scope of commodity derivative position limits should be limited to agricultural contracts and physically settled contracts. There are also questions on transferring the responsibility for position limits from the FCA to trading venues. If taken forward, the thrust of these changes should mean a less restrictive commodity derivatives regime, with greater scope for firms to hedge certain positions.

Reporting requirements: The review acknowledges that reporting requirements can be duplicative and place a burden on firms; it invites respondents to identify specific reporting requirements which are duplicated across wholesale markets. The report also asks whether the 10% drop in reporting rules for portfolios should be revised and broader questions about the balance between investor protection and transparency with respect to regulatory reporting. All of this suggests that further changes to simplify firms’ reporting requirements are on the cards, although it appears HMT is being cautious at this stage, choosing not to put forward many specific proposals until it has first heard from firms.

Trading venues and SIs: the report contains a number of more technical questions around the regulatory perimeter for trading venues, lifting the restrictions on matched principal trading by multilateral trading facilities (MTFs) and whether firms which operate an organised trading facility (OTF) should also be allowed to operate an SI. There are also questions on whether SIs should be determined qualitatively instead of via the current quantitative thresholds for different asset classes. Moving to a qualitative determination would remove the need for firms to make complex quarterly calculations and prevent firms from having to opt into the SI regime across all the instruments they trade, simply to avoid having to make these calculations. In line with many of the consultation’s other proposals, the totality of these changes seeks to broaden the trading landscape available to market participants in the UK and give trading venues greater scope to offer different and innovative execution arrangements. This approach would also give the UK’s regulatory regime additional flexibility, allowing the FCA to issue guidance on the perimeter of the SI regime depending on how the market evolves.

If HMT moves forward with the broad range of policy suggestions proposed, then we expect the UK’s wholesale markets to operate under a less prescriptive regime than at present, and one which will give market participants greater freedom in how they execute trades and may in time lead to a broader range of execution venues flourishing.

How do the UK’s proposals compare to the EU’s forthcoming MiFID review?

While this consultation sets out plans for how the UK will reform its own wholesale markets regulation, the EU is also set to conduct its own review of MiFID II/MiFIR and will publish legislative proposals in Q4 2021/Q1 2022.

Both the UK and EU are looking at many similar areas but are likely to arrive at different conclusions about what changes are needed. Both jurisdictions are committed to the creation of a Consolidated Tape (CT), although the UK is prioritising the development of a fixed income CT, whilst ESMA has called for the creation of an equity CT. While a CT is yet to emerge in either the UK or the EU, the UK may find that it is able to be nimbler and more flexible than the EU. If the UK were to get a limited fixed income CT off the ground this could be a real boon to the attractiveness of its wholesale bond markets.

Both the EU and the UK are looking at the scope of multilateral trading and how it applies to technology companies, with both jurisdictions concerned that the current definition of an MTF may not be sufficiently clear and may fail to capture some companies which bring together buyers and sellers on a more informal basis.

ESMA has proposed amendments to the transparency regime for non-equities, whilst the UK review also dedicates a chapter to the transparency regime, with many of its proposals aimed at taking better account of the difference between equity and non-equity markets. However, the UK proposals appear to be more extensive, asking whether “trading or traded on a trading venue” basis for determining pre and post-trade transparency should be removed altogether and replaced with a determination based around whether the transaction is centrally cleared or not (either voluntarily or as part of the EMIR clearing obligation).

Comparing the UK and EU approaches more generally reveals a number of areas where both the UK and EU are minded to make reforms, but in many cases the UK seems willing to make more substantive changes. For example, while both the UK and EU are looking to amend MIFID’s commodity derivatives regime, ESMA recommends narrowing the regime’s scope to “significant or critical contracts” while the UK wants to limit the regime to only agricultural and physically settled contracts. With respect to the double volume cap, the UK wishes to remove it altogether while ESMA has recommended that it becomes a single volume cap via the removal of the 4% trading venue threshold.

It is therefore important to note that even where the EU and UK are agreed that they will make changes to the same part of the current MiFID framework, in many cases they have put forward differing reforms. This may ultimately drive further divergence between the respective regimes, even when a common problem is identified.

There are also some areas where one side has proposed reform and the other has not followed. For example, the UK review suggests scrapping the STO, while none of ESMA’s consultations have recommended this. On the EU side, ESMA has recommended a number of changes relating to algorithmic trading, including extending the definition of algorithmic trading to include trading conducted on SIs and stricter testing of algorithms. The UK’s wholesale markets review asks only one question related to algorithmic trading, and this is with respect to scrapping the requirement for binding market making agreements between algorithmic liquidity providers and trading venues. This suggests there may be some areas of reform where the two sides end up quite far apart.

Conclusion and implications for firms

HMT’s wholesale markets review sets out a wide range of proposals for reforming the UK’s MiFID rulebook, which could be said to amount to the UK’s “MiFID III”. The reforms touch upon a wide range of areas, from execution venues to reporting requirements and market data. They also point to significant divergence from the EU’s own MiFID framework, even before taking account of the additional changes the EU will make to MiFID under its forthcoming MiFID review.

The UK has moved swiftly in setting out these reforms, and we expect to see firmer policy proposals by the end of the year. By comparison, the EU will only start to consult on its own legislative proposals from the year end. The EU’s political process will also mean it will likely be slow to secure approval for any proposals, whereas in the UK these can be adopted more quickly, giving the UK a first mover advantage.

Firms are likely to welcome the simplification of the SI regime, commodity position limits and transparency requirements, as well as the removal of the STO and double volume cap. Overall, these reforms will give firms more freedom and flexibility to achieve their best execution mandates, and allow for a greater variety of execution venues to operate across the UK’s wholesale markets. Furthermore, whilst there is a lack of detail at this stage, firms are also likely to welcome HMT’s willingness to look at simplifying reporting requirements, and should take this opportunity to let HMT know how they would like the reporting regime to look going forward.

Whilst firms based exclusively in the UK are likely to welcome HMT’s reforms, international firms with a presence in both the UK and EU will face an additional compliance burden from having to deal with two increasingly divergent sets of rules. Consequently, HMT will want to consider carefully where it could align its approach with any changes made in the EU’s MiFID review, without compromising on its objectives for UK wholesale markets. Striking a balance in such areas would reduce the potential loss of efficiency from firms having to comply with two increasingly diverse wholesale market regimes.