The MiFID and the Markets - Unleashing the Trading Forces

1. The MiFID and the Markets -Unleashing the Trading Forces September 2008 Mike Jones

2. What is The MiFID about? • . Customer protection Ending the concentration rule to provide competition to exchanges The core Lisbon objectives Greater transparency Across all trading activity Unifying EU countries around regulation, providing a single passport. Driving down the cost of capital

3. Trading structure and trends • . Buy side – Institutions and retail asset managers Sell side – Institutional sales & trading The trend is towards an increase in principal trading from 50% to 70% by 2015. Algorithmic trading is growing quickly in the UK – it accounts for 1/3rd of US trades (source IBM) Regulation -Exchanges -Multi-Lateral Trading Facilities -Systematic Internalisers -Centralised Counterparty Clearing -Settlement through Centralised Security Depositary Systems (CSD’s)

4. Receiving & Transmitting v Executing Broker Fund Manager Client Client Market Receiving & Transmitting –L2 Art 45 Executing- L1 Art 21 Best outcome For clients Best interest Of clients

5. Where does Best Execution apply? – Cobs 11 “A firm must take all reasonable steps to obtain on a consistent basis the best possible result for a client. • . The best possible result for a retail client is to be determined in terms of the total consideration, representing the price of the financial instrument and the costs incurred by the client related to execution.” It applies inside or outside the European Community Best execution exists when a contractual or agency obligation exists with a client Best Execution It applies to retail and professional clients, but not eligible counterparties It applies to all instruments, on and off market

6. Prioritisation of execution factors • . Price Best Execution Cost Size likelihood of settlement Speed Liquidity

7. Best Execution steps Step2: Selection of execution venues Step1: Selection of factors Step3: Linkage To execution venues Step5: Periodic review Step4: Execution Of order Select venues for ‘Best Possible Result’ on a consistent basis Sort clients and instruments. Prioritise factors – price, cost, speed, etc. All venues ‘Best Possible Result’ venues Best conditions

8. Markets Markets Systematic Internalisers Electronic market place providers Recognised Investment Exchange (RIE) Quote driven (internalises client orders and cross against trading book) Multi-lateral trading facilities (facilitates trades – is neither a buyer or seller) MTF Regulated markets Quote driven Order driven Quote driven Order books Anonymous crossing systems London Stock Exchange Plus Markets SWX Europe (Virt-X) Chi-X Eurex derivatives ICAP Cantor NYSE Euronext – Alternative Nasdaq OMX Nyfix Euro Millenium (dark pool – Euro equities) Turquoise (September 2008) ABN Amro Deutsche Bank Lehman Brothers Merrill Lynch Citigroup UBS Credit Suisse

9. London Stock Exchange – A Recognised Investment Exchange LSE Tradelect services SETSQX (RM – previously SEAQ, Seats Plus SETS (a Regulated Market) Previously SETS/SETSMM Other services SEAQ (MTF – previously SEAQ) AIM – Exchange Regulated Market/MTF Equities & Fixed interest Equities & Fixed interest Equities Equities Order book and integrated electronic market making Quote driven market making Uses SETS, SEAQQX, SEAQ Quote driven together with periodic order book auctions Securities outside SETS and SETSQX, AIM FT All Share plus some Fledgling and AIM UK50 FT all remaining main market, FT Fledgling, some AIM • Eurosets – RM – Equities, order book and integrated market making – Dutch liquids • EQS – MTF – Equities – Quote driven Market making – EURM liquid securities • IOB – RM – Dep. Receipts – International order book Market Maker can enter 2 sided quotes using electronically executable quotes MM can deal off exchange as SI. Allows Limits, Iceberg, Market, Executable quotes. Trades novate to central clearing

10. LSE SETS – an Order Driven system Here is an example of the order book in continuous trading mode: Buy (Bid)Sell (Offer/Ask) Time Volume Price Price Volume Time Order A 10:15 4,800870871 5,900 10:25 Order B 10:22 1,500 870 871 7,500 10:48 Order C 10:18 8,700 869 872 13,800 09:25 At 11:00 XYZ submits a Limit order to sell 10,000 shares with a limit price of 870. Two buyers are prepared to pay 870, which is the highest bid price on the book. The one on earliest gets first go, and 4,800 of XYZ’s shares are sold at 870, leaving XYZ with 5,200. XYZ then sells 1,500 to the remaining buyer, who is prepared to pay 870. The bottom buyer now moves to the top of the book, but is not prepared to pay XYZ 870 – he would only pay 869. XYZ has 3,700 shares left, so XYZ now joins the order book himself, and goes straight to the top of the Sell side, as his selling price of 870 is more attractive to a buyer than the other sellers, who want 871 and 872.

11. LSE SEAQ – A Quote Driven system

12. LSE SETSQX – A mixture of quote driven & order driven • . Settles outside CCP on a bi-lateral basis in Euroclear/Crest Brokers telephone orders Yellow strip shows best available bid & offer Market Makers provide non-electronic executable quotes and liquidity Quote book ----------------------------------- Order display which periodically uncrosses Same order book technology as SETS, but not continuous order book execution. 4 uncrosses daily. RSP Electronic quotes Brokers’ electronic RSP gateway Market Makers enter orders to order book uncrossings Brokers enter orders – only named or anonymous limit orders – no market orders or iceberg orders Orders executed electronically on the order book will be reported to CCP if the security is supported. Non-supported securities settle direct in Euroclear/Crest

13. Plus Markets – a Recognised Investment Exchange, operating a Regulated Market and a Multi-Lateral Trading Facility • . Off exchange quotation facilities for Systematic Internalisers in liquid shares MM will trade report (deals between non-mm members seller reports) through normal venues for that stock Offers Protected Trades, i.e. MM accepts an order that is to be executed within a specified period on an improved basis. The trade must be of sufficient size end (minimum E45,000) to qualify for deferred publication up until end of MQP for current business day 10% share of FTSE Smaller Cap 40% share of FT Fledgling 50% AIM of UK retail market 1/3rd 7,500 securities FTSE100 FTSE250 Smaller companies AIM European -Quote driven execution – telephone trading - Quote driven execution – electronic trading through RSP automated ‘RFQ’ services

14. SWX Europe (Virt-X) – a Recognised Investment Exchange, based in London, and regulated by FSA • . Order driven central limit order book A wholly owned subsidiary of the Swiss Stock Exchange Operates a Regulated Market for Swiss securities, and is an MTF for non-Swiss securities Swiss blue chips Leading European blue chips Clearing through LCH, Clearnet, SIS X-Clear Settlement through Euroclear, SIS Sega, SIS X-Clear

15. Markets Markets Systematic Internalisers Electronic market place providers Recognised Investment Exchange (RIE) Quote driven (internalises client orders and cross against trading book) Multi-lateral trading facilities (facilitates trades – is neither a buyer or seller) MTF Regulated markets Quote driven Order driven Quote driven Order books Anonymous crossing systems London Stock Exchange Plus Markets SWX Europe (Virt-X) Chi-X Eurex derivatives ICAP Cantor NYSE Euronext – Alternative Nasdaq OMX Nyfix Euro Millenium (dark pool – Euro equities) Turquoise (September 2008) ABN Amro Deutsche Bank Lehman Brothers Merrill Lynch Citigroup UBS Credit Suisse

16. Chi-X “The first order driven Pan-European MTF” • . Order driven central limit order book Order types: -Limit -Market -Iceberg -Fill or Kill (in full or not at all) -Execute & eliminate (execute to fullest extent possible) -Hidden Chi-X FTSE 100 Dutch, German, French Anonymous pre & post trade. Can deal anonymously off market as a ‘dark pool’ Clearing – Fortis EMCF (European Multilateral Clearing Facility) CSD’s Agent Banks Owned by Instinet, which is owned by Nomura

17. Turquoise – a new MTF • . On & off order book trading. Onward order routing a possibility 300 pan European equities 1200 dark market Dark pools allow hidden orders and delayed market release Anonymous pre & post trade Clearing EuroCCP (DTC) Agent banks CCP’s Owned by leading investment banks who account for 45% of European trading. Owner banks provide liquidity through connections.

18. Some new competitors.. MTF’s • BATS Trading – US – FTSE – Fortis Clearing • Equiduct – 53% owned by Borse Berlin – Choice of clearing systems. In testing • Nasdaq OMX – 600 Pan European equities – Order routing services provided by Citi for trades that cannot be fulfilled on Nasdaq OMX platform. 26 Sept. • NYSE Euronext Octopus – 400/500 Pan European blue chips. Central limit order book. November Dark Pools (i.e. Not a public limit order book) • -NYSE Euronext’s Smartpool • -SWX’s Virt-x subsidiary links with Nyfix for Swiss blue chips • -LSE Lehman Baikel (Europe’s deepest lake)

19. Systematic Internalisers “A Systematic Internaliser must publish a firm quote in those shares admitted to trading on a regulated market for which they are systematic Internalisers and for which there is a liquid market.” L1 Art 27, L2 1287/2006/EC Art 21, FSA L3 Mar 6

20. Order Routing Systems Order Routing Systems Morgan Stanley Passport Lehman ETS Merrill Lynch POSIT Neonet - Independent agency broker Trades with Regulated Markets, MTF’s, and 3rd party venues Goldman Rediplus UBS Direct Strategy To client specified market Directed orders Amsterdam, Chi-X, Eurex, LSE, Euronext, SWX Virt-X, NYSE, Australia, Japan, Hong Kong, etc Client To most liquid market Non-directed orders/baskets/blocks Order Types: Best Discretionary Fill or Kill GTC GT date/time Iceberg (publicly displays only a portion of total volume, although total can be executed) Limit Market (unpriced) Sweep (focus) Algorithms split orders to liquidity pools Exhaust - saturate

21. Existing operational structure Clearing system Brokers Settlement system Broker Trading platform Central Security Depository Transaction report

22. Trading Settlement service Shifting the settlement Clearing system Trading platform Transaction reports Broker Central Security Depository

23. The MiFID and the Markets -Unleashing the Trading Forces September 2008 Mike Jones