Summary

The European Securities and Markets Authority (ESMA) has published a statement on the application of the share trading obligation on a hard Brexit which has some unwelcome implications. Under MiFID II/MiFIR, European firms may only undertake trading of EU-traded shares on European venues or third country venues that have been deemed equivalent (the share trading obligation). In a hard Brexit, UK venues will become third country trading venues and therefore European firms will not be able to trade a share on UK venues if it is also traded on an EU venue unless the UK venue is assessed as equivalent. This has the possibility to create significant market disruption and impact the ability of market participants to obtain best execution on Brexit.

However, rather than recognise the UK venues as equivalent, ESMA has deemed that all European shares and 14 UK shares with significant liquidity in the EU must be traded on a European venue in accordance with the share trading obligation. This is regardless of the relative trading volumes and ease of execution of the European venue in comparison to the UK venue. The Financial Conduct Authority (FCA) has been critical of this but as of yet, no UK equivalence decision has been made in respect of European venues. Absent any decision or guidance from the FCA or HM Treasury, UK firms would be required to trade dual-listed shares on UK venues.

The share trading obligation

The share trading obligation requires firms to ensure the trades it undertakes in shares admitted to trading on a regulated market or traded on a trading venue take place on:

(i) a regulated market or multilateral trading facility;
(ii) a systematic internaliser ("SI"); or
(iii) a third country trading venue assessed as equivalent.

This means where a share is traded on a European venue all trades by firms must either be on a European venue or on an equivalent third country venue. Shares cannot be traded on a third country venue that has not been assessed as equivalent even if a better price could be obtained. There are certain, limited, exemptions from this rule in particular if trading is non-systematic, ad hoc, irregular and infrequent, it is not subject to the share trading obligation. However, this exemption is inherently limited in its scope as if there is regular trading in a share it does not fall within this exemption.

These rules were introduced as part of the MiFID II legislation with the aim of ensuring that more trading took place on 'lit' venues with regulatory oversight and increased transparency. When MiFID II was being implemented many market participants were worried about the impact of the share trading obligation on dual-listed shares. Under the rules a dual-listed share on an EU and non-EU venue must be traded on the EU venue. As an example many US technology stocks have secondary listings on European venues.

However, the main source of liquidity is on the US venue and there are sometimes multiples of hundred more trades on the US venue compared to the EU venue. Firms therefore might be concerned that, in particular where they had large or urgent orders, they would not be able to achieve best execution for their clients if they were required to execute shares such as Apple on a European venue.

These issues were not helped when ESMA interpreted the concept of "undertaking a trade" as not merely meaning execution. ESMA stated "where there is a chain of transmission of orders concerning those shares all EU investment firms that are part of the chain (either initiating the orders or acting as brokers) should ensure that the ultimate execution of the orders complies with the requirements under [MiFID]." This means even if a firm does not execute a trade but instructs a broker to execute they are still required to ensure the share trading obligation is met where the share is in scope of the obligation.

Solution under MiFID II

Fortunately, this issue was largely solved for MiFID II in two ways. First, a number of third country venues in key jurisdictions such as USA and Switzerland were assessed as equivalent. This meant that an EU firm could trade shares on these equivalent venues as if they were EU venues. Second, ESMA stated in the absence of an equivalence decision ESMA considered trading in shares admitted to trading in a third country's regulated markets would not be considered as systematic, regular and frequent in the EU and therefore not subject to the share trading obligation. Therefore the requirement to execute on a European venue was largely limited to primarily European traded shares.

Brexit and the ESMA decision

On Brexit, UK venues will no longer be considered European venues for the purposes of MiFID II and will instead be third country trading venues. Likewise, in the UK onshoring of the MiFID II legislation, European venues will be third country trading venues. Absent any further decision (either an equivalence decision or an overarching Brexit deal) this means that where shares are dual-listed, a UK firm would be required to execute on a UK venue (such as LSE) whilst a European firm would be required to execute the same share on a European venue such as Euronext.

Market participants have therefore repeatedly called for pragmatism in this area to ensure that this scenario does not arise on a hard Brexit and they are still able to access the best venue for their trades. However, ESMA has now stated that any share with an EU ISIN (the company is established under the laws of a European jurisdiction) will be subject to the share trading obligation and therefore firms will not be able to undertake a trade on a UK venue. ESMA has also listed 14 UK shares (those with GB ISINs) that will be subject to the share trading obligation because it has deemed there is significant liquidity in the EU. All other GB shares will be considered to be traded on a "non-systemic, ad hoc, irregular and infrequent way". Therefore European firms:

• must execute European shares on an EU venue (regardless of where primary liquidity is);
• must execute the 14 GB shares on an EU venue (regardless of where primary liquidity is); and
• may execute other GB shares in whatever way it sees fit.

This statement has been met with consternation by market participants who see the fragmentation of the market as harming their ability to seamlessly trade shares and obtain best execution. This is because there are a number of European shares with primary listings (and liquidity) on a UK venue such as the LSE. Likewise, of the UK 14 shares deemed subject to the share trading obligation the majority have their primary liquidity on the UK markets. By requiring these shares to be traded on an EU venue only European firms are at a disadvantage and not able to meet the best interests of their clients. The FCA has also responded that this has the potential to cause disruption to market participants and issuers of shares based both in the UK and the EU.

Ironically firms outside the UK and EU will be able to execute on the venue that allows them to obtain best execution.

Solution

The most effective potential solution is identical to the one listed above when MiFID II came into effect - equivalence. Post-Brexit the UK will be compliant with MiFID II (certainly more compliant with MiFID II than other third country venues and probably more compliant than some EU jurisdictions given the haphazard implementation in some EU jurisdictions). There is no legal or regulatory reason not to provide an equivalence decision in respect of UK shares. Indeed, providing an equivalence assessment would assist firms in meeting their best execution obligations and ensure limited market disruption.

Likewise the UK should be able to provide an equivalence decision in respect of European venues. The FCA and HM Treasury appear more sympathetic to the arguments of market participants and have indicated that they are willing to engage constructively with ESMA on this issue. However, ESMA has not indicated that it is willing to deem the UK equivalent. Whilst the UK has made more positive noises about equivalence decisions and the issues faced by the market, the lack of an equivalence decision from the EU makes it less likely that the UK will unilaterally deem the EU equivalent or disapply the share trading obligation in respect to certain shares.

Next steps

The market will await any confirmation from the FCA and HM Treasury on how the UK share trading obligation will apply. Ultimately however the decision will be taken in the context of the wider political ramifications of Brexit.

There is also limited scope for market participants to structure around this issue given the wide definition of “undertaking” in the ESMA Guidance.