Download 05 October 2012 Dear Sirs, FIA European Principal Traders

05 October 2012
Dear Sirs,
FIA European Principal Traders Association (FIA EPTA) welcomes the opportunity to submit comments
on the ESMA Consultation paper on the Exemption for market-making activities and primary market
operations.1 FIA EPTA is an association of European principal traders formed in June 2011 under the
auspices of the Futures Industry Association (FIA). FIA EPTA represents more than 20 principal trading
firms that, on a combined basis, are responsible for significant volumes of trading in many asset classes
on European-regulated markets and multilateral trading facilities (MTFs). On average across the main
trading venues in Europe, one in two transactions in futures and one in three transactions in equities are
very likely to have a FIA EPTA member firm on one or both sides of the transaction.2
Timing
As a general matter, we are concerned that the Consultation has been launched only six weeks before
the entry into force of the Short Selling Regulation on 1 November 2012. In particular, we are acutely
aware that ESMA will not finalise the Guidelines on exemptions for market-making activities on the Short
Selling Regulation in a timely manner given the close proximity of the date of entry into force. The
exemption for market-making activities is a key provision of the Short Selling Regulation for our
members; its final scope and the conditions that our members must meet for an application to be
approved will have significant impact on individual firms and on the wider market.
We are aware of ESMA’s workload and that the deadline for entry into force is outside ESMA's control,
but the timing with regard to implementation of the Regulation makes it very challenging for our members
to comply.
FIA EPTA Members are concerned that the Consultation includes provisions that will potentially have a
damaging effect on liquidity and efficiency in the equity, sovereign debt and CDS markets. A three-week
consultation period is a very limited time to provide substantive and detailed feedback. As a result, our
letter focuses on key recommendations and concerns arising from the Consultation paper. We are, of
course, willing to provide further detailed feedback if requested by ESMA.
1. Notification procedure on an instrument-by-instrument basis
As stated in Article 17(1) of the Short Selling Regulation (SSR), the exemption for market makers applies
to activities in a financial instrument and would apply to trading in any financial instrument where our
members are performing any of the activities listed in the exemption. Therefore, we have great concerns
on the “specific-instruments”-approach proposed by ESMA based on, as we understand it, the legal
interpretation of the Commission. We do not share this interpretation and would instead propose an
approach that market-makers should notify their Competent Authority based on the classes of
1
Regulation (EU) 236/2012 of the European Parliament and the Council on short selling and certain aspects of Credit Default
Swaps
2
These ratios are based on estimates of the association and the understanding that each transaction has two sides.
instruments, such as EU sovereign bonds, EU sovereign CDS, EU equities and derivatives, rather than
on an instrument-by-instrument basis.
Notifying the Competent Authority on an instrument-by-instrument basis is inconsistent with existing
practice and the activities-based market-making exemption proposed in Level 1 of the Short Selling
Regulation (SSR). We would welcome further clarification from ESMA on this issue.
The major concerns we have with reporting on an instrument-by-instrument basis are:

The specific details of an instrument provide in our view no meaningful information to
Competent Authorities to make a determination as to whether a firm is acting in a marketmaking capacity for the purpose of the Regulation. The key determination should focus on the
activities that a firm is performing in connection with financial instruments.

The proposed instrument-by-instrument notification is overly restrictive and will cause a huge
administrative burden both for the investment firms and Competent Authorities. Members
estimate that the number of exemptions could result in a considerable amount of notifications,
which will prove to be unworkable.

Requiring market makers to apply for the exemption from short sale restrictions on an
instrument-by-instrument basis and/or to create an artificial distinction between market-making
activities and so-called "proprietary trades" would lead to unnecessary costs with no discernible
benefit.
Experience, drawn from the national short selling notification procedure in Spain and Italy, has shown
how important workable market-making exemptions are for the continued provision of liquidity to the
markets. The Spanish market-making notification procedure, for example, has created signficant
problems for market makers given the overly complicated forms and extensive details required by the
regulator.
FIA EPTA believes an “instrument class-by-instrument class” approach should be adopted by
Competent Authorities, as this refers to classes of instruments in which a firm makes a market rather
than notifying at the individual ISIN, contract or even issuer/reference entity level.
2. Notification period
The 30-day rule necessarily implies a time lag in the ability to engage in market-making activities,
something which will influence spreads and volatility in the market and in the end adversely impact
investors.
As a general matter, the 30-day notification period included in the Level 1 text of the Short Selling
Regulation is based on activities-based approach and is therefore not consistent with an approach to
notify the Competent Authority on an instrument-by-instrument basis. In addition, we have two main
concerns with regard to the 30-day notification period:

Firstly, we understand the 30-day notification period will be applied to newly issued financial
instruments. Applying the 30-day notification period to new financial instruments would be
severely restrictive, and have a grave negative impact on the liquidity of the new instrument and
attractiveness to invest in such an instrument. Consequently, the ability of companies to raise
capital in the financial markets will be limited and innovation in new financial instruments will be
disincentived. We therefore believe that a different approach needs to be taken for new financial
instruments and would request ESMA to include transitional solutions with regard to this matter.

Secondly, we are concerned by the timing and lack of clarity in which investment firms need to
notify their Competent Authority when subsequent changes to the use of the market maker
exemption occur.
3. Market-making scope and 90% quoting obligation [Q1]
Forcing market makers to post firm quotes at competitive prices 90% of the overall trading time on a
given financial instrument, regardless of the asset class or prevailing market conditions is, in our view
without precedent. Requiring a quoting obligation of 90% of the time in a given financial market might
work in highly liquid markets, but when dealing in derivative markets or in markets for less liquid
securities this high number would be far too onerous.
A “one size fits all approach” of proposing 90% presence is inconsistent with ESMA’s approach in its
Guidelines on automated trading. Quoting 90% on the majority of the financial instruments regardless of
prevailing market conditions presents significant risks to an investment firm. Firms must be allowed to
pause and assess current market conditions, especially if market information is unavailable or unreliable,
or trading would require firms to take on positions outside of their risk tolerances.
We would also like to stress that the 90% quoting time is in no way referenced in the Level 1 text of the
Short Selling Regulation and that the text does not mandate ESMA to include such an affix to the
definition. We therefore would like to request further clarification on where this number is coming from in
view of the inconsistencies outlined above.
4. Market-making exemption based on total facts and circumstances
As stated above, market-making activity is often broader than providing liquidity on displayed markets in
a single product. It is a complex process driven by the dynamic order behaviour of other market
participants and the market maker’s risk models and inventories at a given point in time. Because
market makers hold such an important place in the fabric of the market, it is critical to have clear
guidance on the scope of activities that qualify for exemption.
We strongly urge ESMA to define bona fide market-maker activities based on the total facts and
circumstances (discussed below).
Incidental liquidity removal
In the course of providing liquidity, market makers dampen volatility by holding themselves out as ready
to buy and sell on a regular and continuous basis. An essential part of a market-maker's ability to
seamlessly post bids and offers sometimes includes removing liquidity from the market, which may
include short selling. This flexibility is critical for the market maker to be able to bear the risk of providing
tighter spreads and liquidity in any particular stock, and without it, volatility is likely to increase. Therefore
any definition that forces market makers to carve out trades that incidentally remove liquidity from their
market-making transactions would be artificial and counteract the benefit of the market-making
exemption.
Hedging
The market-maker exemption must be comprehensive enough to encompass necessary and reasonable
hedging activities arising from market making. FIA EPTA would like to see further clarification on how
market makers should provide information regarding related transactions in the underlying of a financial
instrument.
Arbitrage
The current text asks market makers to distinguish between so-called “proprietary” trading or arbitrage
activities and their market making activities. Market-maker transactions are always proprietary
transactions, so differentiating between these concepts does not provide useful information. Separating
arbitrage on a transaction basis, likewise, does not take into consideration the full scope of a market
maker’s activities.
In the Consultation, however, arbitrage activities, in particular those executed between different financial
instruments but with the same underlying security e.g. ETFs, convertibles, options and ADRs, are not
considered market-making activities and therefore cannot be exempted. It is important to note that
arbitrage activities are a key component in providing liquidity to the market and are therefore an essential
component of certain market-making activities, for example when engaging in such financial instruments
and the underlying, the arbitrageur essentially also engages in market making as he provides quotes on
both sides of the market. Furthermore, in the same way a market maker incidentally removes liquidity
from the market to balance its inventory, improve pricing and manage its risk, it may also engage in
arbitrage transactions, in particular trades executed in different financial instruments with the same
underlying security.
Any definition that requires market makers to carve out trades that are deemed arbitrage as separate
from their market-making transactions could be artificial and counteract the benefit of the market making
exemption. In addition, if arbitrage is not considered to be a legitimate component of market making, it
would imply that arbitrage activities do not provide liquidity. We would strongly disagree with this and one
could argue that by removing all arbitrage activities from the scope of the market-making exemption, the
Regulation, at least with respect to this issue, is demonstrably going to result in lower levels of liquidity
for certain instruments.
Total facts and circumstances
As we have stated above, FIA EPTA is currently concerned that the cost of complying with these
exemption provisions is just as onerous as the cost of complying with the short-sale restrictions without
the exemption. Because the burden on market makers to obtain the exemption is so high, we are
concerned this regulation may ultimately result in driving some liquidity out of the market.
Therefore, we strongly recommend that ESMA adopt the approach taken by the SEC in implementing
relevant market-maker exemptions under Reg SHO; i.e. to make a determination of whether or not a
market maker is engaged in bona-fide market making based on a "total facts and circumstances"
analysis. Under this analysis, factors that would indicate a market maker is engaged in bona-fide marketmaking activities may include, for example, whether (i) the market maker incurs any economic or market
risk with respect to the securities (e.g. by putting its own capital at risk to provide continuous two-sided
quotes in markets), (ii) a pattern of trading that includes both purchases and sales in roughly comparable
amounts, (iii) continuous quotations that are at or near the touch on both sides and that are
communicated and represented in a way that makes them widely accessible to investors, (iv) having
formal agreements in place with exchanges and/or issuers with regard to liquidity provision obligations,
and (v) with respect to electronic trading firms, the extent to which their documentation describing their
algorithms indicates whether strategies are liquidity taking or liquidity providing. Finally, the scope of
activities included in the market-making exemption should include reasonable hedging activities and an
acknowledgment that incidental removal of liquidity and arbitrage activity are consistent with the total
package of providing liquidity to the market.
Competitive prices of orders
Regarding competitive prices of orders, we believe both options could work, however, option A is more
common and should therefore be preferred.
5. Separate arrangements for middle and back-office activities [paragraph 41 (3)]
We appreciate the aim of paragraph 41, which we understand is to enhance transparency, but it should
be up to the Competent Authorities to achieve this goal. We believe it is unwarranted to explicitly require
separate arrangements for middle- and back-office activities when other means would achieve enhanced
transparency.
When interpreted strictly, the provision 41(3) requiring members to have a clear and definite separation
of middle- and back-office activities would lead to a substantial extra operational burden and would be
very difficult to implement in time to comply with the Regulation by 1 November. In addition, we question
that a strict interpretation of this requirement would actually result in any significant risk mitigation. In any
case, this requirement would seem more applicable to an activities-based exemption than an instrumentby-instrument exemption suggested by the Consultation. Therefore, FIA EPTA members would ask
ESMA to provide further explanation on what is meant by “separate arrangements” for middle- and backoffice activities as outlined in chapter V.I. General Principles, 41(3).
Conclusion
FIA EPTA members would very much appreciate the opportunity to be part of a constructive dialogue
with ESMA on the issues raised in our response. We would welcome an opportunity to meet with ESMA
to discuss these concerns in more detail.
Respectfully Submitted,
Remco Lenterman
Chairman
FIA European Principal Traders Association