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our Vision for European Financial Market priorities

Capital markets play a vital role in the economy as they unlock society’s capital for productive financial investment. The European Union – now more than ever – needs strong and globally competitive capital markets to underpin its political ambitions. Investment needs to be channeled efficiently for the EU to remain competitive in the global digital economy and to fund the transition to a low- carbon economy. In this paper, Optiver Europe shares its vision of EU capital market priorities for the next 5 years.

Proposed Financial Market Priorities​

Optiver has been an active market maker on European exchanges for over 30 years. During this time, we have witnesed the European capital markets undergo enormous change – the increased use of technology, the entry of non-traditional players into the market as well as a major regulatory overhaul (MiFID 1 and MiFID2/R).

As liquidity providers on multiple global exchanges, we believe that markets serve the economy best when they are transparent, multilateral and centrally cleared. Fair regulation should support healthy and efficient markets. For the EU to make markets more efficient and resilient, we should now focus on a few areas that we need to get right:​

Now is the time to get the next phase of the EU it’s capital market ambitions right. We have already made huge progress in terms of harmonising the EU capital markets – the focus should now be on making the markets genuinely competitive globally.

Europe’s capital markeT ecosystem

Capital markets have evolved to include a variety of stakeholders that interact with each other with the goal of optimizing long-term investment value and managing financial risks. Through this, capital markets serve the real economy, whether it is to finance economic activities or to manage the wealth of future retirees. Market participants can roughly be divided into buy-side, sell-side and intermediaries:
Buy-side | these are the ultimate holders of assets and financial contracts. They range from wealth managers (which includes anything from sovereign wealth funds to family offices) to retail investors, hedge funds, insurance companies and non- financial corporates. These participants trade in financial instruments that can be categorised into the following groups:
Exchange-listed | stocks, ETF’s and exchange-traded derivatives have a primary listing on an exchange, typically a regulated market. Price discovery for exchange-listed products is the most transparent compared to any other category, but the economics of these products are too generic to suit all investors’ needs. Exchange-listed financial instruments are considered to be the least risky to the financial system, as they are standardized, transparent, centrally cleared and marked to market by 3rd parties.
OTC products | OTC products: Currencies, bonds & OTC derivatives generally do not trade on exchanges, even though they are quite standardized. And there are various structural reasons for that, depending on the products class. Although for OTC derivatives there is a trend towards exchange-listed or at least centrally cleared solutions, products such as FX options and Interest Rate Swaps are still primarily traded in the OTC space.
Non-standard products | Non-standard products: depending on buy-side demand, banks design tailored products to suit investor needs. These can entail tailor-made derivatives constructed to manage company-specific risks, or structured products that are designed to enhance return on equities or bonds but with a higher risk profile. The low interest rate environment in Europe and Japan have increased demand for non-standard products. However, their complexity and reduced liquidity pose a higher risk which in turn can have spill-over effects on other parts of the market.
Sell-Side | The sell-side’s role is to take over financial risks from the buy-side and recycle these risks into the same or correlated financial instruments. This is why any changes to market structure or regulation in a certain field of financial instruments can have effects on other parts of the markets. Participants on the sell-side consist of:
Non-standard products | Non-standard products: depending on buy-side demand, banks design tailored products to suit investor needs. These can entail tailor-made derivatives constructed to manage company-specific risks, or structured products that are designed to enhance return on equities or bonds but with a higher risk profile. The low interest rate environment in Europe and Japan have increased demand for non-standard products. However, their complexity and reduced liquidity pose a higher risk which in turn can have spill-over effects on other parts of the market.
Sell-Side | The sell-side’s role is to take over financial risks from the buy-side and recycle these risks into the same or correlated financial instruments. This is why any changes to market structure or regulation in a certain field of financial instruments can have effects on other parts of the markets. Participants on the sell-side consist of:

Figure 1 | Europe’s capital market ecosystem | Diagram of market participants in financial markets. Buy-side decides what to trade and as a result ends up with a certain choice in sell-side firms that can take the other side. In some cases the transaction will happen on a trading venue, but can also be done directly with a sell-side firm. For transactions that are more difficult to handle, brokers can facilitate the search for a counterparty while trying to limit information leakage.

The main message of this diagram is twofold. At first it illustrates that the scope of financial instruments is very wide but due to hedging activities very interconnected (also shown by the web of connections between sell-side, intermediaries and trading venues). For example, investment banks that sell non-standard products use other product classes to hedge their risks. Retail investors who due to regulation cannot trade exchange-traded derivatives resort to contracts-for-difference which are less transparent and less safe. The CFD operator in turn hedge their risk on trading venues or a sell-side firm.

Secondly, trading venues are not always an independent 3rd party. Dealer-to-client platforms are often owned by sell-side firms in order to establish direct trading lines with the buy-side. While this is useful for optimizing execution for buy-side, the lack of transparency can have a negative effect on the quality of all-to-all venues which are the prime source for price discovery.

October | 2019

Market Structure

EU equity markets post MiFID2: What is still needed for truly integrated, competitive and transparent markets?

Transparency – an EU consolidated tape that will benefit the end-investors | One of the main objectives of MiFID2/R was to enhance transparency in European equity markets. While a lot has been achieved, a consolidated tape for all bond and share transactions (post-trade) below the large-in-scale threshold (LIS) transacted on any venue (including Systematic Internalisers) should be prioritised to further transparency and help investors in their price discovery process – a process which should be seen as performing a ‘utility’ function for market participants. To date, it apprears that no commercial provider has found it commercially attractive enough to offer this consolidated tape service, so it will likely need to be mandated by the EU authorities.

To assist with the implementation of a consolidated tape, we suggest to only require reporting bonds and shares below large-in-scale transactions from the post- trade side. It is possible to add consolidated pre-trade order books to this tape, but it should be noted that this is more costly to realize. In addition, it requires investor education as this liquidity cannot be guaranteed due to the geographical separation of the lit markets involved. We believe a consolidated tape is especially important for listed shares of small and medium sized enterprises (SME’s), as these shares generally have lower trading frequency but these firms play a very important role in the economy while often having difficulties finding sufficient investors.

The battle for order flow – multilateral trading that improves price discovery | Another important MiFID2 objective was to stimulate multilateral trading ‘on-venue’. This has not materialised as envisaged by policy makers. A recent study shows that in the first eight months of 2018, lit market share averaged at 42.41% compared with 42.37% for 2017.1 Instead, MiFID2 has led to growing trading levels on Systematic Internalisers (SIs). The reasoning behind the favouring of SIs is that quotes on a public market are at greater risk than those exposed to a bilateral trading relationship via an SI. This can create a vicious circle. As more trading takes place on SIs, the public markets will see less of the ‘benign’ order flow and will widen their quotes to compensate for the increased risk. This in turn would widen the SIs’ quotes which references public market pricing and is dependent on the quality of the public market’s price formation process. To preserve the quality of European equity markets, these trends need to be monitored closely by EU authorities. To counter this potential vicious circle, the SI regime should to be reviewed and tightened. The needs that the SI regime is meant to address could be met in other ways, discussed in the next section on innovative trading models.

How bilateral trading models can undermine public market liquidity

Market makers compete for order flow by showing their liquidity on regulated markets, Multilateral Trading Facilities (MTF) and Systematic Internalisers. The basis for posting limit orders is a model that creates estimates of a fair price and standard error for a financial instrument. The higher the standard error, the larger the margin that the market maker will need to post liquidity due to adverse selection. Besides volatility, the level of information of incoming order flow affects this. Systematic Internalisers (SI) allow for trading with known counterparties and can therefore provide tighter prices than public trading venues. As a consequence, market makers need more margin for their orders shown on lit exchanges on which SIs themselves are relying for price formation. Besides that, the increased fragmentation of trading makes it more difficult for institutions to trade European cash equities and prove best execution.

Innovative trading models – fostering innovation in the order book to make EU’s capital markets competitive globallyThe central limit order book (CLOB) has been the classic electronic multilateral trading model for decades. However, new technology and functionality have given market participants more options to optimise the execution of their trades. Examples include periodic auctions, mid-point trading and request for quote (RFQ), which deal with the issue of information leakage more efficiently than the CLOB model but are still multilateral.

After all, the price discovery process is best supported by liquidity providers that are able to reflect their view of the price in an anonymous and publicly accessible market as long as the risks associated with doing so do not outweigh the rewards

Regulation should not restrict these innovative trading developments – as long as the principles of pre-trade transparency are met and the functionality remains purely multilateral (i.e. allowing any market participant with an economic interest to participate in a trade). Regulators should be vigilant against attempts to make trading bilateral, for example through internalisation, broker preferencing, or covert payment- for-order-flow (PFOF) by attaching costs to other services in relation to trading.

Unifiying Europe’s post-trading environment – one step closer to CMUA genuine EU Capital Markets Union will require important adjustments of legal and fiscal frameworks – which are still very embedded in existing national legislations. Today, it may still be politically difficult to tackle some of those questions – for instance the question of harmonising fiscal treatment of investing income might not be politically palatable. However, if we want to achieve a CMU, the post-trading enviroment should be the first area of focus. This means aiming either (1) for a single clearing house (CCP) and depositary for European cash equities, or (2) for multiple CCPs that are fully interoperable, which could support a majority of trading within the different

venues in Europe.
We do understand it would require adjustments to individual country’s incumbent organisations by consolidating them under a single (non-profit) service provider under European law (comparable to the DTCC model in the US). However we are convinced that the CMU will not come to fruition until the EU fully harmonises its legal framework for clearing and settlement of securities.

Financial Transaction Tax – one step away from CMU?A small group of EU member states is currently discussing a plan to implement a harmonised version of a Financial Transaction Tax among 10 member states. Such an initiative would appear to run counter to the objective of a globally competitive EU capital markets union. A working paper published by the ECB in 20161 concluded that a securities transaction tax introduced in Italy in 2013 had decreased liquidity and increased volatility in affected securities.

Besides this, imposing such a tax at the level of only 10 out of 27 member states, seems to run counter to the need for a much higher level of integration of our rulebook for capital markets. Tax remains a key incentive to capital flows – and it is important to assess the impact of such a FTT-10 on the EU’s stated ambition to develop globally attractive, autonomous, deep and liquid capital markets.

Execution services can mimic payment- for-order-flow (PFOF

Brokers that have a market making arm can offer execution services – such as order routing and best execution reports – for very low prices in return for sending that order flow to their own market maker. As the order flow has been filtered out, the spread that the market maker earns will be more than enough to compensate for offering the execution services below cost price. This is perhaps not explicit payment-for-order-flow, which is prohibited under MiFID2, but it has a similar effect on the market. It hides the true cost of execution for market participants, and should therefore be unbundled similarly as was done for financial research services.

The relevance of derivatives to capital markets

Alongside the future of European equity markets, a key component of success for the EU CMU project will depend on the state of the EU derivatives markets, given how those are linked to the quality of markets overall.

The primary function of a derivatives market is to transfer financial risks from a hedger to a risk-taker. For centuries, futures contracts have been used as a cheaper and more efficient alternative to trading underlying assets, and as such have improved price discovery for these underlying assets.

Derivatives and ‘cash’ markets are linkedThe close relationship between derivatives and capital markets is often underestimated. While underlying securities fundamentally determine the pricing of derivatives, efficient derivatives markets also form a crucial component of cash market liquidity.

Prices of derivatives send useful signals to enable economic stakeholders to quantify financial risks more accurately when making business decisions. For example, a European manufacturer of machines with a large client base in the United States may have analyzed that it can remain in business as long as a US Dollar does not drop below €0.75. By analyzing FX options prices this manufacturer can estimate the cost of insuring against such an adverse currency move for years in advance, and use this information to optimise its business planning.

Evolution of European derivatives markets | While European derivatives markets have developed considerably since the introduction of the Euro in 1999, we have witnessed a slowdown since the Global Financial Crisis ten years ago (see Annex 1). This contrasts with our observation in other geographical areas, most notably in the United States, Hong Kong and some emerging markets where markets have grown even faster in the past decade.

There are a number of reasons why European derivatives markets have stayed behind, but it is our observation that European retail and even some institutional investors have partly moved away from investing on European exchanges. Instead, they have turned to contracts-for-difference (CFD’s) and bank-issued structured products. The opaque nature of these products often leads to higher costs and risks for investors than exchange-listed alternatives. Aside from this, some European investors have shifted to using US markets for their investment needs, even for products with European underlyings.

It should be noted that US regulation limits the use of unlisted and structured products, and instead makes it easier for private investors to trade listed derivatives on transparent markets. Therefore we suggest that the barriers to access financial derivatives in Europe be evaluated, education on this matter encouraged and that the regulation with respect to off-exchange alternatives be reassesed.

How derivatives liquidity supports the cash market

The role of derivatives markets in cash market liquidity is often overlooked. For example, equity index futures play a vital role in the liquidity posted in the underlying shares of the index, because basket arbitrageurs will post liquidity on the lower and upper bounds of the shares representingthefairvalueof the index through the futures contracts. Some benchmark index futures contracts, such as the widely used Euro Stoxx50 futures listed on Eurex, are more liquid than the underlying cash market as there is a lot of hedging demand on a continuous basis. At the same time, market makers are rewarded by quoting the product based on a multiple of inputs, of which the cash market itself also plays a role. This liquidity excess in futures contracts benefits asset managers who regularly adjust a portion of their equity benchmark holdings cheaply through these products (instead of directly in the cash market). In the European bond markets, the reliance on derivatives is even larger. Most of the European government bond trading is referenced to futures contracts listed on Eurex. Without these bond futures, government bonds would be a lot less liquid and price discovery of the interest rate market more difficult.

The figures below illustrate how European derivatives markets (blue) have been outgrown by their US peers (red) especially since the Global Financial Crisis.

Issues affecting the quality of European derivatives markets

EU investment firms capital requirements | A number of EU investment firms play a significant role in global derivatives markets. It will be important as Europe develops its new prudential regime for those investment firms to distinguish market participants in terms of their size and whether they are funded by their own money or by deposits held by customers. Compared to proprietary trading firms, hedge funds deal with other people’s money being at risk while still being subject to a lighter prudential regime.

Capital requirements for EU investment firms should reflect the actual risk the real economy runs. The EU detailed Level 2 rules for the prudential framework for investment firms are still to emerge, but it will be important to ensure those rules do not lead to EU investment firms falling under a similar regime to banks. Those investment firms may have large balance sheets, but the net-postions are small and they trade with their own money instead of client deposits.

If the capital requirements for investment firms are not calibrated well, Europe runs the risk of losing a substantial amount of the ‘know how’ and experience of its investment firms to competing firms (and banks) in other jurisdictions. It will harm the EU’s capital markets, and gives another segment away to competitors in the US, who are already very dominant in many parts of Europe’s investment services. With London soon to be outside of the European Capital Markets Union, Europe cannot afford to lose highly qualified professionals in an industry vital to the efficient functioning of its capital markets.

Margin offset example

An iron ore producer wishes to fix his sales prices for 2 years, but a steel mill has a horizon of 1 year for stabilizing its cost of raw material. A market maker could take on both risks as they have an offsetting nature, while accepting a residual risk on the term structure of iron ore, which in this case is the difference in the price of iron ore from one year to the next. Margin offsets reduce the cost of this position to a level closer to the actual economical risk, which is reflected in the market maker’s quote spread. An appropriate methodology will also limit unnatural price distortions in the term structure due to certain positions becoming too crowded.

Margin offsets / SA-CCR | Derivatives differ from equities or bonds in that they are margined instead of paying the full notional amount of the underlying asset. Best practices and regulations require derivatives positions to have initial margin and daily variation margin in place in order to prevent large cash streams from losses building up over a longer period of time. The initial margin amount depends on a methodology measuring the overnight risk of the position.

A large number of participants offset (i.e. hedge) the risks of their derivatives portfolios by buying or selling related financial instruments. The resulting reduction of initial margin is referred to as margin offsets. Margin offsets play an essential role in the efficiency and liquidity of derivatives markets, as they reduce the cost of holding inventory with reduced risk profiles. It is of utmost importance that regulation on derivatives positions is kept up to date with the latest insights in actual financial risks, in order to prevent price distortions and drying up of liquidity, especially during times of market stress.

Europe’s derivatives markets are currently facing the negative consequences of applying the Current Exposure Method (CEM) for clearing members. These clearing members are banks that facilitate the trading of exchange-traded derivatives (ETD’s), and have to deal with margin requirements that are based on a methodology designed before liquid option markets existed and does not include the netting methodologies that are used by CCP’s risk management models. A direct effect is that the business model of these clearing members is under severe pressure, leaving market participants with fewer choice of clearing members and higher costs. It is therefore recommended that EU national supervisors frontload the Standard Approach to Counterparty Credit Risk (SA-CCR), which is in itself not perfect but a lot less flawed and problematic than CEM.

To prevent EU derivatives markets from drying up over the coming years, this needs to be resolved within months rather than years.

Transparency in derivatives markets | Transparency plays a key role in price discovery – which forms the basis of any investment decision. MiFID2 was introduced to enhance transparency of European markets in general, including OTC derivatives. Unfortunately there are still large issues surrounding the quality of OTC derivatives data. Contrary to the United States where the Swaps Data Repositary (SDR) gives a lot of useful insight on trading activity, the MiFID2 data still lacks crucial parameters (such as forward starting dates, standardised price notations and options strikes) or these parameters are not filled in by the firms reporting them. The lack of high quality data from OTC derivatives traded in Europe reported under MiFID2 hampers price discovery. We endorse the intention of MiFID2 to bring this transparency, but the result so far has fallen short of expectation.

Margin offset example

An iron ore producer wishes to fix his sales prices for 2 years, but a steel mill has a horizon of 1 year for stabilizing its cost of raw material. A market maker could take on both risks as they have an offsetting nature, while accepting a residual risk on the term structure of iron ore, which in this case is the difference in the price of iron ore from one year to the next. Margin offsets reduce the cost of this position to a level closer to the actual economical risk, which is reflected in the market maker’s quote spread. An appropriate methodology will also limit unnatural price distortions in the term structure due to certain positions becoming too crowded.

EU investment firms in global derivatives markets

A number of EU investment firms play a significant role in providing liquidity in global derivatives markets and in return contribute to the health of the EU’s capital markets. 

The issues outlined above regarding capital requirements, margin offsets and transparency could put their business models at risk. We have already observed that US banks have become very dominant in OTC derivatives in Europe over the last 10 years, and the same could happen to ‘on-exchange’ liquidity if regulation were to become a serious competitive disadvantage to EU non-bank liquidity providers, and therefore weaken the European capital markets as a whole. With Brexit causing London to be outside of the EU, the continent needs the expertise that exists within the Union even more to further strengthen its own capital markets.

Transparency in derivatives markets | Transparency plays a key role in price discovery – which forms the basis of any investment decision. MiFID2 was introduced to enhance transparency of European markets in general, including OTC derivatives. Unfortunately there are still large issues surrounding the quality of OTC derivatives data. Contrary to the United States where the Swaps Data Repositary (SDR) gives a lot of useful insight on trading activity, the MiFID2 data still lacks crucial parameters (such as forward starting dates, standardised price notations and options strikes) or these parameters are not filled in by the firms reporting them. The lack of high quality data from OTC derivatives traded in Europe reported under MiFID2 hampers price discovery. We endorse the intention of MiFID2 to bring this transparency, but the result so far has fallen short of expectation.
resources

1_ECB Working paper nr. 1949 / August 2016: The stock market effects of a securities transaction tax: quasi-experimental evidence from Italy: https://www.ecb.europa.eu/pub/pdf/scpwps/ecbwp1949.en.pdf?38fb4df3077b0682e43edac0a2f665be
2_Rosenblatt Securities analysis -https://www.rblt.com/news/why-mifid-ii-is-missing-the-mark-nine-months-in

Willem Sprenkeler

Head of Public Affairs

Claire Nooij

Manager Public Affairs & ESG

About optiver

Over thirty years ago, Optiver started business as a single trader on the floor of Amsterdam’s European Options Exchange. Today, we are a leading technology-driven market maker, with more than 1000 employees in offices around the world, united in our commitment to improve the market by competitive pricing, execution and thorough risk management. By providing liquidity on multiple exchanges across the world in various financial instruments we participate in the safeguarding of healthy and efficient markets.
We provide liquidity to financial markets using our own capital, at our own risk, trading a wide range of products: listed derivatives, cash equities, ETFs, bonds and foreign currencies.