A brief history of on/off-exchange

Hailed by legislators as the new framework to close loopholes, MiFID II will see OTC trading face new restrictions, most importantly in the form of the Systematic Internaliser (SI) and the new trading obligations. As the fog slowly lifts, it’s becoming apparent that these new restrictions could impact market structure in surprising ways. A more detailed analysis shows that ETFs, ADRs and other similar financial instruments will face comparable requirements to equity shares. Whilst SIs are not attractive for derivatives that face the risk of a trading obligation, they might compete for market share in other non-equity instruments. And finally, OTC trading without an SI will be limited to a very small market share, irrespective of the asset class.

It’s perhaps premature to start drafting a eulogy for OTC markets, but what’s certain today is that the relationship between on- and off-exchange trading will become more intricate under MiFID II. Being a glass-half-full kind of guy I took great solace in reading Ranald C. Michie’s book, The Global Securities Market: A History, which tells us that the battle between competing sectors is nothing new. Michie tells the story of how the first formal stock exchange was founded in Paris in 1724 and immediately the market separated into “agents de change” (aka on-exchange) and an alternative market that flourished in the streets outside the exchange building (aka OTC) trying to avoid government imposed limitations. And he describes how in 1871 an OTC market developed in New York alongside the exchange because of disagreements on commission models.

So, even centuries ago, exchange and OTC markets have competed against each other on market quality, regulatory burden and cost. Any changes under MiFID II are merely one more chapter (and certainly not the last) in the long history of markets. The current regulators’ aims will undoubtedly be met, but we should also remember from past experience that markets have a tendency to rebalance and innovate.

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