ESMA MiFID II / MiFIR Consultation and Discussion Papers General Comments on Market Structure Issues

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1 August 2014

ESMA MiFID II / MiFIR Consultation and Discussion Papers

General Comments on Market Structure Issues

Financial markets have changed and technology has evolved meaningfully since 2007 when MiFID I was implemented across Europe. In the aftermath of the 2008 global financial crisis, regulators worldwide declared vigilance in their efforts to ensure market transparency and investor protection. Regulatory reform to implement G20 commitments to enhance the integrity of the financial system represents both the updating and reconfiguration of legislation governing global financial markets.

BlackRock welcomes the opportunity to comment on ESMA’s proposals for detailed rule making presented in its MiFID II / MiFIR Consultation Paper (CP) and Discussion Paper (DP) and would encourage ESMA to read these general comments alongside our responses to the CP and DP. The issues that ESMA cover are important for asset managers such as BlackRock, given that we typically interact with the data vendor, market venue or broker, seeking to achieve the best possible outcomes for our clients, Europe’s investing public. Consequently, the views we represent in this note and the

responses to the ESMA CP and DP are those which we believe will bring about the best outcomes for our end-investors clients in terms of investment performance, cost, transparency and confidence in Europe’s market infrastructure.

General comments

Academic research suggests that market fragmentation has increased with the proliferation of venues and technologies, which were precipitated by the implementation of MiFID I. However, the end result of this is debatable as competition has also increased with the proliferation of venues. While fragmentation across venues or exchanges is usually regarded negatively, the research shows that it is competition among liquidity providers rather than venues per se that drives market quality. In other words, a

“fragmented” market with many venues but perfect information linkages is equivalent to a centralised market. However, trade fragmentation with imperfect competition and imperfect information linkages may lead to negative outcomes such as greater volatility and less liquidity.

Although further work is necessary to address deficiencies in European ETF and fixed income market structure, BlackRock believes that the current European equity trading ecosystem generally serves investors well. Since MiFID I was implemented:

 There has been a continued trend towards electronic trading across all asset classes and in particular, equity.

 Where they exist, electronic order books have matured and systems have become increasingly more efficient and appealing to investors.

 Whilst remaining an issue of debate, there is a degree of consensus that high frequency traders (HFT) today provide a service to all market participants by connecting pools of liquidity which helps tighten the bid-ask spreads of the securities for which they make markets.

 Trade reporting of large orders can be deferred to minimise market distortion.

 Consolidated tapes paint a more complete picture of a given security’s liquidity across venues, although a reliable tape does not yet exist on a regional basis.

Therefore, we believe that end-investors would ultimately be best served by a targeted and limited adaptation of the regulatory framework rather than a radical overhaul. Policymakers today should take account of the clear benefits, as well as the potential risks, of any new measures around trading of diverse asset classes. We set out a number of general points per asset class which are important for Europe’s end-investors before responding to the questions in the CP and DP.

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2 EQUITY & ‘EQUITY LIKE’ INSTRUMENTS

Post-trade transparency and consolidated tape

Where consolidated tapes do not currently exist, end-investors continue to be disadvantaged. At the same time, supervisors are denied a key tool to meaningfully assess trading patterns and monitor market integrity. This is currently the case in Europe. Hence asset managers currently find it difficult to answer two simple questions in relation to European equity: what is the price of a stock? And how many shares have been traded?

Effective post-trade transparency is dependent on the delivery of harmonised and high quality data. In our view, a precondition to the delivery of that data is the application of common and harmonised reporting requirements as a priority across the market. We would also support the adoption of harmonised standards in respect to the timing of post-trade publications. We welcome efforts by the FIX trading community who have taken on the administration of defining the Market Model Typology (MMT), which aims to provide a consistent standard for trade reporting.

Once these standards are in place, authoritative post-trade data at reasonable commercial costs should emerge via competing consolidated tapes, reflecting the diverse needs of end-investors. However, if a credible commercial solution is not forthcoming for the provision of comprehensive consolidated trade data, we would encourage ESMA to advise the Commission to mandate a single authoritative

consolidated tape provider.

Where consolidated tapes already exist, it is also possible to subscribe directly to market data feeds disseminated by exchanges and venues. By consuming these private feeds, participants are able to obtain faster delivery of market data since they are not subject to the processing delays inherent in consolidation and redistribution. Additionally private data feeds may reflect information, such as odd lot orders and transactions, which is not contained in the consolidated tape. This creates an un-level playing field for real-time data, which is an impediment to price discovery and intricately linked to concerns about the execution quality of off-exchange trades. We would encourage ESMA to take this into account in developing detailed rules to implement MiFID II / MiFIR.

Finally, and specifically for ETFs, we would be supportive of a trade reporting regime in which availability of deferred publication for large transactions takes into consideration multiple layers of liquidity inherent in ETFs. The differences in the dynamics of the markets for ETFs compared to shares requires any delayed reporting of ETFs to be based on transparent and objective criteria to determine the thresholds for deferral. We urge ESMA to ensure the full range of Exchange Traded Products (ETPs), which includes ETFs as well as Exchange Traded Notes (ETNs) and other Exchange Traded Instruments (ETIs) are appropriately categorised within the regulation with the appropriate level of transparency.

Liquidity definition, pre-trade transparency and off exchange liquidity

One of ESMA’s key tasks in developing implementing rules for the new MiFID regime will be to define a liquid market for equity and ETFs. The definition of a liquid market will determine the use of pre-trade transparency waivers but given the multiple layers of liquidity, ETFs do not share the same liquidity characteristics as shares. This means that the measures relevant to define a liquid market for shares (average daily transactions, average daily turnover and free float) are not wholly appropriate for the ETF market. We set out in the responses to the questions proposed solutions for defining a liquid market and the situations under which pre-trade transparency waivers may be applied in the ETF market.

More generally, as a user of the full range of execution venues in pursuit of best execution for our end- clients, BlackRock remains concerned with a public policy emphasis that seemingly “protects” lit markets, and by doing so restricting innovation and investor choice, rather than by providing lit markets with the flexibility to compete. Whilst we do recognise the policy goal of maintaining the integrity of the price formation process in public markets, we have previously asked policy makers to recognise that the choice to transact in non-pre-trade transparent environments in sizes below Large-In-Scale (LIS) can offer

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several benefits to investors, issuers and the wider market. For example, it can facilitate the interaction of natural buyers and sellers with similar interests and time horizons at improved prices and allow immediate execution for investors at the best price, but at a larger size than normally available on public markets.

Hence we have supported a policy approach that seeks to meet the goal of mitigating any unintended consequences of the current pre-trade transparency waivers for equities, whilst continuing to allow investors the choice of executing in non-pre trade transparent venues when it offers meaningfully better execution results.

In our view, whilst the volume based trading venue and total caps (“double cap mechanism”) for the Reference Price Waiver (RPW) and Negotiated Trade Waiver (NTW) which are now written into the Level I text will have the limited effect of capping the total level of EU trading under waivers, their operation is very likely to prove to be impractical and will have a profound and damaging impact on the efficiency of EU financial markets and the real economy. The caps will, we believe, result in investors reducing their willingness to trade and, as opposed to shifting liquidity from dark to lit, may indeed reduce overall liquidity. In our view the double cap mechanism will also likely lead to:

 an increase in costs for investors (as investors, users and market operators factor in the risk of discontinuous trading);

 an increase in the cost of capital for companies;

 an increase in trading in substitutes like Contracts For Difference (CFDs) and spread betting; and

 potential leakage of business from the EU.1

The market is looking to ESMA to design implementing rules for the double cap mechanism in as sensitive a way as possible, applying first to the more liquid stocks before being eventually rolled-out to the less liquid, typically Small and Medium Enterprise (SME) stocks whose liquidity is more susceptible to the impact of the caps. We would encourage ESMA to carry out meaningful and frequent reviews of the impact of the caps on overall market liquidity and proactively recommend changes to their application if their presence is deemed to be detrimental to market liquidity.

Tick size regime

Whilst we agree with the principle of having a harmonised and appropriate pan-European tick size regime for shares, BlackRock does not believe that the regulation of tick sizes should be mandated for ETFs as we do not see evidence for the requirement for a wholesale change to tick sizes. ETF issuers and trading venues cooperate to ensure that newly listed and existing ETFs have the most appropriate tick size that does not harm price discovery or result in reduced liquidity. We believe an inappropriate tick size regime will drive liquidity off lit venues. Implementing either one of the tick size regimes as currently proposed by ESMA will result in material changes to tick size regimes that will have a negative impact on end-

investors.

Tick sizes for ETFs have evolved with the market to a point where all participants are of the view that they are broadly “correct”. The factors that determine an ETF tick size are more nuanced than for an equity and include liquidity of the underlying securities, secondary market liquidity of the ETF and size per trade as well as the currency of the trading line (there are generally multiple currency trading lines for each ETF).

Changes to any tick size regime could have a material impact on markets and any change should have a level of flexibility that takes into account the nuances of ETF liquidity. Trading venues, issuers and market participants provide a level of expertise that should be utilised to ensure the stability of markets. We would urge ESMA to look afresh at this section and if it is deemed that Level 1 requires a tick size regime

1 We have suggested that a better approach might be an obligation for all trades executed using a waiver to offer meaningful improvement to the public price. This would achieve the same policy objective – i.e. decreasing the level of dark trading and mitigating any impact on price formation, without the unintended consequences. It is also consistent with international regulation on dark trading – Canada and Australia have implemented this policy with positive results. As a principle, we believe MiFID should support investor choice for execution in continuous markets and achieve regulatory certainty – the meaningful price improvement approach can accomplish this.

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for ETFs, consult afresh with the market on a tick size regime designed to accommodate the specificities for ETF trading.

High frequency and algorithmic trading

BlackRock is firmly opposed to predatory High Frequency Trading (HFT) practices which seek to

manipulate the market or disadvantage end-investors. These practices may constitute market abuse and should be treated as such in law. Exchanges and regulators need to establish a robust framework to police and identify abuses, and to act on manipulative practices when found. Furthermore, regulators need to assess where loopholes may exist and work to close them. We are confident that ESMA’s proposals will address the key issues in need of reform.

However, HFT encompasses a wide variety of trading strategies and care must be taken to differentiate predatory practices from practices that benefit end-investors. For example, “electronic market making” is a type of HFT that brings tangible benefits to our clients through tighter spreads and by delivering intermediation in a fragmented trading landscape. Additionally, HFT is difficult to distinguish from computer-based trading tools such as algorithms or smart order routers which are used by market

participants to execute orders for institutional and retail investors. All are characterised by low latency and automated order management. But, electronic market making and algorithmic trading are both activities which are legitimate elements of market structure and help asset managers achieve best execution for clients. As such, BlackRock urges ESMA to consider carefully how HFT should be defined and the impact that policy decisions will have on these beneficial market activities.

Post-trade connectivity and access

In advance of the MiFIR provisions on access and interoperability coming into force, the industry is working to simplify post-trade connectivity for ETFs which is a key impediment to investors benefiting from pan-European liquidity in the product. We believe that open access to Financial Market Infrastructures (FMI) trading, clearing and settling of ETF orders and to market indices, will provide European end- investors with enhanced choice in trading and clearing services. This development reduces the risk of concentration present in closed FMI structures, and should eventually lead to fewer settlement failures, lower costs, deeper pools of liquidity for given instruments, improved service levels and innovation in financial markets.

NON-EQUITY INSTRUMENTS

Pre- and post-trade transparency in fixed income

BlackRock emphasises the importance for users and ultimately end-investors of maintaining appropriate market structure and regulatory requirements governing pre- and post-trade transparency applying to fixed income markets.

Market participants have observed a global policy trend over recent years centred on extending equity- like pre- and post-trade transparency requirements to fixed income markets. Theory suggests that transparency may reduce adverse selection, and that in turn will reduce bid-ask spreads on average.

Greater transparency may also reduce search costs for investors. When investors search more, this increases competition among dealers, which narrows bid-ask spreads.

On the other hand, greater transparency could reduce the supply of liquidity. Once a liquidity supplier has purchased securities, he usually endeavours to re-sell at least part of the purchase, to manage inventory.

If his competitors have observed this initial trade, however, they may be tempted to react

opportunistically. Knowing the liquidity supplier needs liquidity and is willing to pay for it, his competitors will adjust their prices. Thus after large trades in transparent markets, liquidity suppliers trying to unwind inventory can be in a weak bargaining position. This will increase the margin, or widen the bid-ask spread, they will require from investors to offer liquidity risk in the first place and ultimately impact the returns end-investors receive on their savings.

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Whereas an appropriate level of transparency is beneficial for investment, conversely, incompatible

“equity-like” levels of transparency applied to fixed income markets could reduce information acquisition and revelation in the market place, with the following consequences. For investors mandated to hold bonds as part of their investment strategy, the tendency will be to invest predominantly in only sufficiently liquid bonds, to minimise market impact and trading costs. Many investment mandates are already restricted to a limited universe of the strongest sovereigns and the largest corporates. In turn, the adverse market activity will reduce the ability of investment managers to diversify their portfolios, impede the ability of companies to finance their future growth and hinder some governments’ ability to finance their debt.

The market will place relatively less importance on a pre-trade transparency regime for fixed income.

Whilst it is important that a pre-trade transparency regime is sufficiently calibrated and flexible not to adversely impact liquidity in a given issue, post-trade transparency is a more meaningful investment tool.

Therefore, we have welcomed ESMA’s recognition of the need for a calibrated and dynamic post-trade transparency regime for fixed income. In our detailed responses we have suggested areas in which ESMA’s proposals could be developed further to ensure that reporting to the market is appropriately calibrated to take into account the underlying liquidity dimensions of non-equity instruments.

Derivatives trading obligation

Although there is scope to phase in the trading obligation, liquidity in products will be best maintained, we believe, through a big bang approach where all market participants become subject to the trading

obligation at the same time. The date for the trading obligation to take effect should necessarily be set a reasonable time after the final phase of the clearing obligation has commenced in order to ensure all market participants have sufficient time to prepare.

Due account should also be taken of package trades where at least one leg of the package would not be subject to a trading obligation. A separate determination should be made as to whether they should be subject to the trading obligation and at what point in time. Package trades, or any component of a package, should not be subject to the trading obligation simply by virtue of the fact that one component on its own is subject to the trading obligation.

Commodity derivatives

We are broadly supportive of ESMA’s work on defining the European regime for commodity derivatives.

This has been an issue of much debate throughout Level 1 and in our view ESMA is closing in on an approach which recognises the specificities of the market whilst delivering on the high level political objectives to review this aspect of market structure. A number of points are particularly important to note:

 Global coordination in respect of position limits methodology, to ensure that frameworks developed in different jurisdictions are compatible and, where appropriate, harmonised. This is relevant both in the contexts of position limits and reporting.

 An approach that preserves a degree of flexibility to ensure that limits can be expressed in the most appropriate way for a given market, taking into account the approach followed by the trading venue in question.

 A position reporting regime that serves to monitor position limits. We particularly support the expressed will to standardise the data definitions and the format of the reporting information required by MiFID with other existing legislative texts to the greatest extent possible in order to reduce the scope for duplicative reporting.

 An interpretation of the Level 1 text that maintains that where a fund manager manages multiple funds with distinct investment strategies, the assessment of position limits will take place at the level of the ‘person’ or fund.

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