Philippe Theyras

Oct 11, 2019

This second article summarizes the key regulatory challenges raised by ESMA regarding periodic auctions. The final report of their call for evidence highlights three main topics: pre-trade transparency, price formation and the self-matching feature. But don’t expect any firm instructions.

The report provides a clarification exercise that practitioners should welcome, in particular regarding price formation where they dissect order price types. In addition, ESMA points out that most aspects of periodic auctions are not problematic per se. However, in a specific context and in combination with other factors, it may prove challenging. It is the cocktail mix of ingredients that can raise the regulatory red flag.

Pre-trade transparency: the need for a standard starting time

Two subjects related to pre-trade transparency are under ESMA scrutiny: imbalance information and the starting time of the auction.

Regarding imbalance information, for now, only indicative executable price and volume are disclosed during the call period. Most stakeholders are reluctant to provide imbalance size or side as published in conventional auctions due to front-running risks and information leakage. RTS 1 does not currently require the disclosure of market/order imbalance. ESMA does not intend to take any action regarding information imbalance. 

The subject of the auction call starting time is more complex and is a key element that distinguishes the two types of Frequent Batch Auctions (FBAs). Normally, the auction call starts when a potential match is identified (as described in the previous blog), except in the CBOE model where the first order triggered it. ESMA will provide further guidance on this issue in the coming months. 

The regulator considers it "important that trading venues provide market participants with information that an auction has started."

 

Price formation is a main focus 

Three practices may undermine price formation: pegged orders, price collars and locked-in pricing. 

1. All periodic auctions accept pegged order type either to bid, offer or mid-point of the venue’s BBO (Best Bid and Offer) collar. For some respondents, it does not weaken price determination and provides certainty of execution. This is especially the case for less sophisticated investors and it is viewed as a major advantage of FBAs. Most systems also automatically adjust an incoming limit order that is outside the BBO so that, for limit buy and sell orders, the limit is set at the respective BBO price prevailing at the point in time when the order was submitted. This feature is called ‘‘adjusted limit orders’. ESMA states that auction systems that only allow the submission of pegged orders and/or adjusted limited orders should only operate under a reference price waiver. Therefore, ESMA suggests that all auctions should accept unadjusted limit and market orders to ensure venues are truly price-forming.

2. All periodic auctions use a price band limitation referring to prices determined by other systems (such as the PBBO) or an EBBO they have constructed themselves. Most respondents argued that this mechanism ensures that transactions always reflect current market conditions and therefore contributes to orderly trading. On the contrary, other respondents indicate that they are de facto reference price systems. ESMA is generally supportive of the use of price band limitations but its analysis of the average price spread in the top 10 liquid instruments constituents of EUROSTOXX 50 shows that “limiting price movements within the EBBO prevents any price movement” at all. For that reason and in order to achieve a meaningful price determination, price band limitations should not make reference to prices determined by other systems. An alternative solution should be to provide a reasonable band, perhaps by using an EBBO with a specified number of ticks either side of it. In short, price collars should not be too narrow. Again, ESMA will provide further guidance in the coming months on this matter.

3. Some periodic auctions (namely GS Sigma-X MTF, UBS MTF and MS MTF) operate on the basis that the matching orders that initiate an auction set the auction price. Locking-in prices offers price certainty. The majority of the respondents did not consider that such systems are price forming, especially when those systems allow the use of mid-price pegged orders. In ESMA’s view this feature used in combination with self-matching, increases the risk of using FBAs for the formalisation of pre-arranged transactions. ESMA indicates that it should only be used by systems allowing the submission of (unadjusted) limit orders. Further guidance will be issued in the coming months.

 

Self-matching: Is it really controversial?

All FBAs allow for self-matching, which is defined as the possibility of two orders from the same broker to be matched. Some auctions also offer broker preferencing, meaning opposing orders from the same member are matched ahead of other orders at the same price. It is worth noting that self-matching functionalities, and in particular member preferencing, are already in place in most CLOB systems.

“It would make sense to limit the practice across all order books, not just FBAs,” stated in Oslo Borse’s response.

While the initial concern about the broker preferencing, was that it could be used to bypass the need for the negotiated trade waiver, ESMA recognises that there is no evidence that it is actively being used to formalise negotiated transactions. Research from AIMA indicates that pairs of trades routed to FBAs cannot be assumed to match with any certainty. Consequently, ESMA will clarify through upcoming guidance that the use of self-matching should not be used to formalise privately negotiated transactions but only genuine internalisation flow.


Conclusion

As noted in the previous article, ESMA acknowledges the beneficial impact of the innovative trading mechanism introduced by periodic auction books. Nevertheless, it does not mean carte blanche. In the final report of their call for evidence, ESMA draws lines to indicate where the dark spots are. The upcoming guidance on regulatory issues should be seen as an opportunity to move further along the learning curve of an innovation that is gaining ground in the European equities trading landscape.

Written by

Philippe Theyras

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