2002/0269 (COD) Proposal for a DIRECTIVE OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL ON INVESTMENT SERVICES AND REGULATED MARKETS, AND AMENDING COUNCIL DIRECTIVES 85/611/EEC, COUNCIL DIRECTIVE 93/6/EEC AND EUROPEAN PARLIAMENT AND COUNCIL DIRECTIVE 2000/12/EC

(presented by the Commission)

Table of contents

Explanatory memorandum

Section I. Background to the proposal.

I.1 What is the Investment Services Directive?

I.2 Europe's fast-changing financial landscape:

I.3. Why do we need a new Directive?

I.4. Broad objectives of the revision:

Section II. An efficient, transparent and integrated trading infrastructure:

II.1 Competition and fragmentation:

II.2. Guiding principles for regulating trade-execution:

II.3. High level principles for regulated markets (title III):

II.4. New core service for "Multilateral Trading Facilities" (MTFs):

II.5. Trade execution by investment firms:

II.6. Conclusions on the regulation of trade execution:

Section III. Investor protection and the investment firm regime (title ii):

III.1. Capital adequacy (articles 11 & 17):

III.2. Conflicts of interest (article 16):

III.3. Conduct of business rules when providing services to clients (article 18):

III.4 Best-execution (article 19):

III.5. Client order handling rules (article 20):

III.6. Dealing with eligible counterparties (article 22):

III.7. Conclusions on the investment firm regime:

Section IV. Scope of the Directive:

IV.1. Investment advice (annex I, section A):

IV.2. Financial analysis (annex I, section B):

IV.3. Commodity derivatives (annex I, section C):

Section V. Other key features of proposal:

V.1. Clearing and settlement:

V.2. Competent authorities and supervisory co-operation (title IV):

V.3. Use of committee procedures (comitology) to implement provisions:

EXPLANATORY MEMORANDUM

Proposal for a Directive on investment services and regulated markets

Section i.: Background to the proposal.

I.1 What is the Investment Services Directive?

The Investment Services Directive, adopted in 1993, sought to establish the conditions in which authorised investment firms and banks could provide specified services in other Member States on the basis of home country authorisation and supervision. Services eligible for a passport under the existing ISD include brokerage, dealing, individual portfolio management, reception and transmission of investor orders, and underwriting/placing activities. In addition, the ISD enshrined the right of direct or remote access of any authorised ISD firm to participate in trading on exchanges/regulated markets in other Member States. To support the effective exercise of this right, the ISD introduced elements defining some characteristics for mutually recognised exchanges which imposed some conditions on the operation of those markets. [1] The ISD is therefore the legal instrument which seeks to translate Treaty freedoms into practice in respect of investment services and organised trading of financial instruments. (see annex 1 for detailed overview of Directive 93/22/EEC).

[1] Notably, publication of details of transactions completed on the exchange.

I.2 Europe's fast-changing financial landscape:

Market based financing is playing an increased role in the financing of European large and medium sized enterprises and in the allocation of European savings. Orderly, transparent and effectively regulated financial markets can serve as an important motor for wealth-creation. [2] In Europe, corporate borrowers have recently turned to financial markets as an alternative source of finance to bank-lending: the number and value of new issues soared in the late 1990s as companies sought access to cheap, dis-intermediated funding to finance ambitious investment projects. Increased supply found a ready demand as investors turned to market-based investments as a means of bolstering risk-adjusted returns on savings and for provisioning for retirement.

[2] Both time-series analysis and international comparisons confirm the powerful contribution that efficient financial markets can make to wealth-creation. Levine & Ross, etc.

Recent reverses suffered by equity markets do not weaken the case for market-based financing. However, they highlight the importance of a robust legal and regulatory framework if investor confidence and liquidity are to be nurtured and financial markets are to thrive. Financial markets can survive periodic bouts of volatility, cyclical corrections or under-performance of individual stocks. They will not survive the erosion of investor confidence if markets are disorderly, opaque and susceptible to market abuse or if intermediaries fail to discharge their fiduciary obligations to the end-investor. [3] The present proposal forms part of a coherent programme of legislative measures to facilitate the emergence of integrated and efficient European capital markets, while imposing proportionate checks and balances to avoid market excess and protect investors.

[3] Schleiffer, Vishny etc (2000), Black (2000).

The integration of EU equity and corporate bond markets holds out the prospect of significant reduction in trading costs and the cost of equity/corporate bond finance. New research suggests that the static efficiency benefits of establishing integrated, deep and liquid equity and corporate bond markets alone are likely to be significant - involving a permanent reduction in the cost of equity capital by 0.5.%, triggering an increase in investment, employment (0.5%) and GDP (1.1%). [4] The benefits of efficient capital markets will be optimised by pooling liquidity, and allowing supply and demand for financial instruments to interact on a pan-European basis. This will maximise the depth of trading interest, reduce stock-specific volatility and limit adverse price impacts for large trades. Pooling of blue-chip liquidity, and the end to geographical diversification strategies can free up capital for new issues markets and venture capital. The introduction of the euro has already paved the way for full integration of unsecured money markets, and significantly boosted integration of sovereign and financial debt markets. Market participants are now looking to extend the same trading and portfolio management strategies to equity business and other asset markets. All of these factors lie behind the recent strong trend growth in cross-border trading of financial instruments: over the last five years, cross border equities trades have been growing at 20-25% per annum.

[4] London Economics: 2002. Quantification of the macro-economic impact of integration of EU financial markets.

In view of the contribution that competitive and flexible market-based financing can make to growth, employment, the Lisbon and Stockholm European Councils have placed integration of European financial markets at the heart of the European economic reform agenda. Harnessing the benefits requires the removal of obstacles to investment transactions together with a comprehensive programme of measures to align national regulatory regimes across all stages of the trading cycle: from disclosure obligations at the time of issue, common guidelines governing trading and the behaviour of market participants, to finalisation and reporting of completed transactions. Building on the FSAP, the Commission has tabled a series of proposals for EU legislative measures which seek to lay the foundations for a coherent regulatory framework for integrated financial markets. This ambitious programme of legislative action holds the key to an important and enduring increase in Europe's employment and wealth-creating potential. The new proposal is an integral part of this programme.

Box: Directive on investment services and regulated markets and related EU legislative measures:

A new ISD will, by harmonising rules for dealing with or on behalf of clients or for own account and promoting the transparent functioning of organised trading systems, facilitate the integration of secondary markets in financial instruments. However, these measures are a necessary but not a sufficient condition for allowing effective cross-border interaction of all potential buy and sell interests in a given instrument. The FSAP identified a number of areas which call for EU-level solutions if a single financial market

Rules harmonising the content and format of disclosure of relevant information by issuers: one of the key roles of financial markets is to reflect all available information relating to a financial instrument in its price. Rules on the information to be disclosed by the issuer at initial offer (prospectus) and on an ongoing basis, are vital if all EU investors and traders are to arrive at an equally informed judgement of the value of a prospective investment (ensure that they are not comparing apples and pears). To this end, the FSAP instigated a comprehensive programme of action in respect of financial information. This encompasses the proposal for Prospectus Directive, emerging work on regular reporting (and ad-hoc disclosure of price-sensitive information) and the (politically agreed) Regulation on International Accounting Standards. The existence of a modernised system for issuer disclosure is also crucial to the ISD objective of allowing regulated markets to compete for liquidity by admitting partner country securities to trading without triggering duplication of disclosure obligations.

Safeguarding market integrity, preventing market abuse: In an integrated financial market, an investor in one Member State will be able to trade securities issued in a second Member State through the systems of a market in a third Member State with a counterparty located in a fourth. Faced with such a scenario, it is crucial that there be a watertight and effective EU regime for detecting and punishing market abuse. Supervisory authorities, market operators and market participants must behave scrupulously, exercise vigilance and cooperate effectively where necessary to prevent cross-jurisdictional abuse from sapping investor confidence. The Market Abuse Directive (now close to agreement) clearly defines prohibited behaviour and establishes stringent disciplines to police and punish abusive practices throughout the EU.

Allowing collective investment schemes to exploit single market freedoms: Collective investment schemes have emerged as a powerful force for managing and intermediating private savings. UCITS currently have a capitalisation of between 3-4 billion euro. The recently agreed UCITS directives will cement the single market framework for unit trusts and mutual funds by expanding the range of collective savings vehicles which can distribute products EU-wide and provide for mutual recognition of fund manager qualifications.

Promoting efficient and competitive clearing and settlement of cross-border trades: impediments to the finalisation of cross-border securities transactions are coming into sharper focus. A high degree of inter-connectivity between different links in the clearing and settlement chain is crucial if investors undertaking a transaction on a market in another EU member State are to be able to repatriate title to those securities without incurring undue costs, delay or risks of "failed trades". There is now a growing understanding of the myriad legal, tax and regulatory obstacles which stand in the way of efficient clearing and settlement of cross-border trades. Some parties to the debate have expressed the view that different ownership and organisational structures for these activities may also result in strategic barriers to competitive provision of clearing and settlement. The Commission has recently published a Communication (COM(2002)257) mapping out a number of strategic orientations and inviting interested parties to help identify EU-level policy responses.

I.3. Why do we need a new Directive?

The existing Directive no longer provides an effective framework for undertaking investment business on a cross-border basis in the EU. It does not establish clear ground-rules within which competition and consolidation of trading infrastructures (exchanges and other trading venues) can take place. The principal shortcomings of the existing ISD include the following:

(1) ISD does not provide sufficient harmonisation to allow effective mutual recognition of investment firm licenses. As a result, the effectiveness of the ISD passport has been heavily mitigated by dual/multiple supervision of cross-border business;

(2) ISD contains outdated investor protection disciplines: the relevant safeguards must be updated to take account of new business models, market practices and related risks. Investor protection rules also need to be reviewed to compel firms acting on behalf of end-investors to make active use of new trading opportunities to get the best deal on the client's behalf. This will ensure that competition between different types of order-execution venue works to the advantage of the end-investor rather than his/her disadvantage;

(3) ISD does not span the full range of investor-oriented services (e.g. advice, new distribution channels) or financial dealing (e.g. in commodity derivatives). Some of these activities, when undertaken as the main or regular occupation of the firm, may pose material risks to investors or market efficiency/stability which could be addressed through the application of ISD and related disciplines;

(4) ISD does not address the regulatory and competitive issues that arise when exchanges start competing with each other and with new order-execution platforms. At the time of ISD adoption, competition between exchanges/trading systems was non-existent. Now, competition between different methods of trade-execution (exchanges, new trading systems, in-house order execution by investment firms) is the principal regulatory challenge confronting EU securities supervisors. The few underdeveloped ISD provisions relating to regulated markets do not provide a sound regulatory framework within which markets and systems can compete for liquidity, and in which investment firms may undertake off-exchange order execution in the context of providing other services to clients;

(5) ISD provides for an optional approach to the regulation of market structure creating a formidable stumbling-block to the emergence of an integrated and competitive trading infrastructure. Article 14(3) of the existing Directive allows national authorities to stipulate that retail investor orders be executed only on a "regulated market" ("concentration rule"). A number of Member States have availed of this option to favour the interaction of retail investor orders on centralised public order books operated by regulated markets. Other Member States have elected not to use this option and have left responsibility to the investment firm to determine how best it can secure "best execution" for its clients. This has resulted in greater diversity of order-execution methodologies in these countries. Such fundamental divergences as to the regulation of market structure have, in turn, given rise to discrepancies between national trading conventions, rules on market operation, scope for competition between order-execution platforms, and the behaviour of market participants. [5] These constitute a significant obstacle to cross-border transactions and fragment liquidity;

[5] For example, Member States which allow off-exchange execution of client orders have been forced to develop more sophisticated "best execution" policies, whereas this have, to a large extent been unnecessary in Member States which require concentration of retail investor orders on a "regulated market".

(6) ISD provisions relating to designation of and cooperation between competent authorities are under-developed: the present Directive is insufficiently clear regarding allocation of enforcement responsibilities within Member States, and does not establish a sound basis for cross-border supervisory cooperation. A fully integrated single financial market requires that proscribed behaviour be pursued and punished with equal severity across the EU. A further pre-condition for an integrated and orderly single market is that there be full and immediate co-operation and information flow between national authorities. Current ISD provisions for supervisory cooperation were designed for a context in which linkages between national financial markets were less intensively employed. These mechanisms need to be substantially revamped:

(7) ISD provisions are inflexible and out-of-date: ISD has to be rewritten because it is unable to respond to pressing regulatory issues caused by evolving market structure and business and supervisory practices. The need to revise ISD testifies to the futility of trying to regulate financial markets by hard-coding provisions in immutable legislation. In the light of the favourable responses of the European Council and EP to the recommendations of the Lamfalussy committee, it is proposed to amend key provisions of the Directive to allow for adoption of legally binding implementing measures the through comitology procedure. This procedure will be used in strict conformity with the inter-institutional understanding between the European Parliament, Council and Commission.

Given the extensive shortcomings of the existing ISD, and the need to render it more responsive to structural change in EU financial markets, the Commission considers that it is more effective and rational to replace the existing text in its entirety. The new proposal incorporates those provisions of the existing ISD which have proved their worth. It builds on the national supervisory and enforcement structures which give effect to the existing ISD. Proposed changes to its scope represent an organic evolution rather than radical change. By building on the foundations established by the existing Directive, it is hoped to limit the extent of legal, institutional and supervisory adjustment which will be required to implement a new text.

Box:- A new approach to EU financial rule-making.

The Financial Services Action Plan drew attention to the underdeveloped EU legal framework for securities markets, and the significant opportunity costs resulting from the regulatory fragmentation of EU liquidity. It identified a number of initiatives to create a legislative framework to support the emergence of a single deep and liquid financial market. As part of this package, the Commission published a Green Paper in November 2000 exploring a number of themes relating to the operation of the ISD. [6] In the light of the 68 responses to the Green Paper, the Commission concluded that a wide-ranging review of the Directive was required.

[6] COM(729) 2000, Upgrading the ISD.

The recommendations of the Lamfalussy Committee of Wise Men, endorsed by the Stockholm European Council in March 2001, have heavily shaped the preparation of this proposal:

1.Consultation of market practitioners and interested parties: since publication of the original Green Paper, Commission services have twice solicited the reactions of interested parties, in an open and inclusive way, to informal and preliminary thinking on the scope and form of ISD revision. A first consultation, which comprehensively mapped out possible modifications to the Directive, was published in July 2001. These preliminary orientations were discussed in an open hearing, attended by 150 interested parties, in Brussels in September 18-19 2001. 77 submissions were received in response to this consultation. Responses prompted a reconsideration of a number of important facets of the original orientations which were criticised as over-prescriptive and inimical to competition and innovation in the provision of order-execution services. Consequently, the Commission published a substantially revised set of orientations for ISD revision in March 2002. The revised orientations were again subjected to rigorous scrutiny in open forum (22 April 2002) attended by 200+ participants. The present proposal has been drafted on the basis of a careful consideration of the 107 responses to these revised orientations.

2.More effective and market-responsive single market rules: the Lamfalussy committee advocated a systematic and rational distinction between high level principles to be harmonised through EU Directives and the promulgation of uniform, legally binding but adaptable implementing measures under "comitology". Under this structure, CESR will prepare detailed technical advice, in the light of reactions to open consultation, to mandates issued by the Commission. This two-tier structure for securities law was proposed as a means of reconciling continuity in democratically established core regulatory principles, with detailed harmonisation required to support cross-border organisation of securities trading and services, and the flexibility needed to adapt to rapidly evolving market practice in fast-moving financial markets. The far-sighted EP plenary vote/inter-institutional agreement on implementation of the Lamfalussy proposals, has cleared the way for the present proposal to be drafted in accordance with the Lamfalussy template.

I.4. Broad objectives of the new proposal:

The proposal for a Directive on investment services and regulated markets aims to strengthen the capacity of the EU legislative framework to serve two over-arching regulatory objectives:

1.the protection of investors and market integrity by establishing harmonised requirements governing the activities of authorised intermediaries;

2.the promotion of fair, transparent, efficient and integrated financial markets: this goal will, in particular, be furthered by the development of ground-rules governing the negotiation and execution of transactions in financial instruments on organised trading systems and marketplaces, and by investment firms.

The new Directive is discussed below under the following headings:

- measures to promote an efficient, transparent and integrated financial trading infrastructure;

- provisions governing provision of investment services, with a view to protecting investors and fostering market integrity;

- proposed extensions to the scope of the Directive;

- other issues (clearing and settlement, supervisory cooperation).

Section II. An efficient, transparent and integrated trading infrastructure:

II.1 Competition and fragmentation:

In Europe, as elsewhere, the functions of market intermediary and marketplace have historically been performed by distinct types of institution. At the time the ISD was adopted, exchanges enjoyed a national franchise for the organised matching of buy/sell interests in locally issued securities. Intermediaries competed with each other in the provision of services to end-investors, issuers and for "over-the-counter" (OTC) dealing. [7] This institutional dichotomy allowed a clear distinction between the reach of investor-facing protections - which applied only to intermediaries - and market-facing rules designed to uphold the transparent and efficient functioning of markets - which applied primarily to exchanges. Since the adoption of the ISD, the EU financial marketplace has become more complex and the boundary between marketplaces and intermediaries has become blurred. IT has allowed the core-business of exchanges to be replicated at low-cost by non-exchange systems and for exchanges to reinvent themselves as competitive market players: there are now more players, more trading options.

[7] In performing this function, large dealers represented an alternative point of liquidity for market participants. The use of the term "market-making" in respect of this activity highlights the extent to which dealers could substitute for on-exchange trading. Therefore, the marketplace/intermediary distinction was by no means watertight.

New developments in EU financial trading:

The following technology-driven trends have transformed the financial trading landscape:

1. inter-exchange competition: the era of utility-run stock exchanges, acting as a single uncontested national liquidity-point, is gone. Profit-driven exchanges are now competing directly for order flow and listings, seeking to expand activities through cross-border mergers or vertically integrating along the clearing and settlement chain;

2. competition from alternative trading systems [8]: new entrants are providing alternative venues for own-account trading by institutional and professional investors. These systems are now the principal organised trading venues for bond trading. However, they account for only 1% of equity trading volumes in the EU (a much lower share of equity transactions than in US); [9]

[8] The term "alternative trading system" (ATS) has entered into common parlance as a catch-all term for a wide range of new trading support facilities whose shared characteristic is that they are not licensed as exchanges. Some respondents to the consultation have noted that this terminology is not suitable for a legal text and does not capture the specific functionality of the entities which its is proposed to authorise as a new core service. In view of this, the term "alternative" has been replaced by "multilateral". The word "system" is replaced by "facility" - to avoid confusion with a well-established bond-trading outfit.

[9] J.P. Morgan (2002).

3. increased internal execution of client orders within investment firms: the concentration of brokerage in the hands of a diminishing number of investment firms and banks is creating a situation in which large volumes of client orders can be executed "in-house" - either by crossing one client order against another or executing against proprietary position of broker-dealers. A diminishing balance of retail investor orders which cannot be executed internally is routed to exchanges for execution. This practice is well established in jurisdictions which have not introduced a "concentration rule": in these countries, available information suggests that many large institutions are currently internalising between 15-30% of client order flow..

Before examining the regulatory challenges associated with competition in trade-execution arrangements, it is important to note the following:

- As far as overall market efficiency is concerned, regulatory measures that directly restrict competition between trade execution arrangements do not seem to deliver improvements in price-formation which would justify an intrusive intervention in market structure to favour exchange execution. Recent analysis of prices of transactions in almost all equities traded on leading European exchanges does not provide any support for the proposition that concentrating transactions on exchanges improves market efficiency (as measured by effective average spreads [10]). (Chart 1).

[10] The effective spread is the difference between the average buy and sell price that an investor actually paid. The effective spread can be defined as EPS = 2 * | P - M| / P. Where P is the effective transaction price and M is the quote mid-point or (Ask + Bid) / 2. It is a more representative indicator of the actual spreads prevailing on any market as it takes the difference between the average prices to buy and sell a share at a given time as opposed to the nominal spread between the best bid and offer available at the top of an order-book and which will only be available to the traders which succeed in hitting those trades. The effective spread presented is the average of the daily spread of a 24 month time series for some 13,000 stocks.

(source: London Economics, 2002).

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>REFERENCE TO A GRAPHIC>

To the absence of any static efficiency benefits from directly regulating market structure must be added the dynamic costs to the marketplace as a whole of restricting participant choice, competition between trading systems and innovation. Competition between trade-execution arrangements can deliver dynamic benefits if it brings down transactions costs, brings additional liquidity to the markets, supports sophisticated trading strategies and helps to streamline transaction settlement. Although other factors are also at work, some support for this proposition may be found in the fact that EU regulatory regimes which allow for competition between exchanges and other forms of trading method are characterised by higher stock market capitalisation (170% of GDP) and liquidity (as measured by turnover 407% of GDP) when compared to Member States which favour trading on-exchange (80% and 130% respectively). [11] Recent evidence, based on US trading, suggests that this increased turnover and market capitalisation increase should fuel a further reduction in trading costs. [12]

[11] Source International Federation of Stock Exchanges and FESE (2002).

[12] There is a negative correlation between Turnover (-0.11) and Market capitalisation (-0.543) and Trading costs. Domowitz, Glen and Madhavan - Liquidity, Volatility and Equity Trading Costs across countries and over time - January 2000.

- These benefits will not be confined to professional market participants. In-house internalisation of client orders can benefit clients in a number of ways: speedier execution, price improvement, and reduction in costs associated with settlement of trades directly within the system of the investment firm. Competition between intermediaries should result in some of these benefits being passed-through to end-investors. These benefits cannot be taken for granted. One of the objectives of this proposal is to create the conditions under which off-exchange execution of client orders only occurs where there is a demonstrable advantage for the client. However, the experience with the Retail Service Providers in the UK demonstrates that off-exchange execution can deliver price improvements for retail investors in 7 out of 10 trades.

- Competition between exchanges and other types of trade-execution arrangements is nothing new: exchanges in all Member States have long been confronted with competition from non-exchange execution for at least some types of trade. Even those Member States which require concentration of retail investor orders on a "regulated market", already allow competition between exchanges and other trading methods for professional and institutional trades. Furthermore, all Member State trading cultures recognise that exchange order-books are not the optimal trading method for all types of transaction. Central order-books exist alongside "over the counter" and upstairs trading for a range of transactions. [13] A number of regulated markets are now seeking to marry the advantages of quote-driven and order-driven trading under one roof. [14] The diversity of trading arrangements in different Member States is tacit recognition that a regulatory framework which favours one type of trade-execution venue will not be able to accommodate the wide variety of trading interests and strategies which make up a competitive marketplace.

[13] OTC trading, upstairs trading, large block trading either on or off-exchange.

[14] Operate on-exchange block trading facilities, or appoint specialist liquidity providers.

If an integrated European financial market is to deliver its full potential, the regulatory environment should allow for the coexistence of different market microstructures, competition between trading systems, and freedom of choice for investors and market participants. Nevertheless, increased competition in trade-execution does present new challenges for the regulatory system in protecting investors and promoting orderly and efficient markets. The new Directive on investment services and regulated markets must provide a coherent and effective framework for managing these challenges. Many of the most complex and contentious issues surrounding ISD revision stem from the blurring of the market-place/intermediary boundary and consequent intensification of competition within and between different types of trade-execution. These challenges can be examined from 3 perspectives:

Fragmentation, and efficient price formation:

The dispersal of trading across a number of order-execution venues can result in the fragmentation of buying and selling interest into shallow and disconnected liquidity pockets. If unchecked, this process could work to the detriment of the two critical attributes of a successful financial market - liquidity and efficient price-formation. [15] In particular, fragmentation can result in wider bid-ask spreads, increased adverse price impacts for trades, and reduced opportunities to trade. [16] Both inter-exchange competition, and competition between exchanges and other types of order-execution venue can contribute to fragmentation.

[15] Liquid markets allow transactions to be undertaken without triggering large price movements against the interests of the trader. In markets which are efficient from a price-formational perspective, prices quoted in the markets will embody all relevant and up-to-date information relating to the "real value" of an instrument

[16] London Economics 2002: The London Economics research highlights the opportunity costs associated with fragmentation of current levels of liquidity between leading EU exchanges.

There is a growing consensus amongst financial regulators and commentators that an effective transparency regime can allow the benefits of competition between trade-execution venues to be reaped, while limiting any adverse consequences for overall market efficiency. "Market transparency - in essence the widespread availability of information relating to current opportunities to trade and recently completed trades - is generally regarded as central to both the fairness and efficiency of a market, and in particular to its liquidity and quality of price-formation". [17]

[17] IOSCO (2001): report from TC on "transparency and market fragmentation" (p. 3).

Efforts to counter the potential adverse effects of fragmentation through appropriate transparency rules should, at the outset, take account of the full range of trade execution arrangements if they are to represent a comprehensive solution. " It would be desirable to have a coherent transparency regime for an asset class that applies across all market venues." [18] A transparency regime which is confined to regulated markets and ignores "off-exchange" trade execution will be partial in reach and sub-optimal in effect. Off-exchange trading which improves on prices prevailing on regulated markets may embody trading information which is relevant for the investment judgements of other market participants in the same way as on-exchange trading. On this basis, it is argued that other market participants should be able to factor information on such trades or trading interests into their investment decisions and thereby maximise the efficiency of price formation.

[18] Idem, p. 13.

However, transparency may come at a price in terms of reduced liquidity provision to market participants. Forcing dealers and broker-dealers to display the terms at which they are willing to buy or sell instruments may reduce their ability to trade at a profit, and expose them to strategic trading by other market participants. [19] In this way, rules which are designed to promote an absolute level of transparency - where all market participants possess all information on all current opportunities to trade, all of the time - would oblige dealers and broker-dealers to expose their trading positions to such an extent that they would no longer be willing to provide liquidity support to the market. This would complicate trading for market participants and investors, particularly in respect of block trades, trades in illiquid stocks, programme trading, and could add to price volatility. Therefore, caution is needed before extrapolating exchange-type regulation and transparency rules to off-exchange trading where market participants place their own capital at risk.

[19] Bilateral trading or internal order-execution do not involve the same trading processes as on-exchange or MTF-based trading. Dealing centres on the provision of quotes on a bilateral/selective basis. Dealer discretion is needed to protect its proprietary capital from exposure to position risk. Regular/continuous position-taking by dealers and broker-dealers (against their own capital) provides liquidity support to the market, which can help to smooth price fluctuations and ensure a permanent counterparty to trade with investors. These considerations do not materialise in the case of exchanges or MTFs: there is no capital of the market/system operator at stake, and market participants/system users are voluntarily and knowingly making use of the system to advertise the terms at which they are willing to trade.

Investor protection:

The structural changes in financial trading and order-execution can also give rise to particular investor protection concerns. One particular concern in this regard concerns the scope for conflicts of interest within broker-dealers which may execute client orders internally against proprietary trading positions - a process widely referred to as "internalisation". The integrated broker-dealer has an incentive to place the interests of its trading desks before the interests of the client. The existence of this conflict of interest raises the question of whether investors/clients can be confident that broker-dealers will comply with their over-riding duty to act in the best interests of the client. These conflicts of interest are already commonplace under the existing ISD and under those national regimes which allow broker-dealers to execute client orders outside the rules of a "regulated market". However, these conflicts of interest may be exacerbated where the investment firm has an active strategy of internalising client order flow and minimising the orders that have to be finalised on-exchange.

A related issue is that market fragmentation may undermine the representativeness of on-exchange prices which have traditionally served as an anchor for "best execution" policies. "Best execution" rules generally provide that investment firms are considered to have discharged their duties to a client when its orders are executed on a "regulated market" or at a price equal to or better than that prevailing on the "regulated market". Widespread order-execution away from the "regulated market" could drain liquidity away from exchanges and undermine the representativeness of reference prices established on regulated markets. Under this scenario, "best execution" policies which benchmark broker performance against the price obtaining on regulated markets lose their relevance as a base-line of protection for clients. Furthermore, faced with fragmentation of trading across disconnected systems and markets, investors or their brokers may not be aware of or have access to the best available trading opportunities. It is important to note that the experience of markets which allow off-exchange order-execution does not lend much empirical support to these claims: bid-ask spreads in shares traded on the LSE SETS order-book have continued to narrow despite the conclusion of a large volume of retail investor orders outside the SETS order-book. [20].

[20] Evidence from EU markets which allow off-exchange retail order execution suggests that fears regarding the degradation of price-formation are overstated. Bid-ask spreads on the London SE electronic order-book (SETS) have narrowed in recent years despite the widespread execution of investor orders outside the rules of the exchange (subject to post-trade reporting requirements). There is no obvious pattern in effective and quoted spreads between Member States which take a restrictive stance on off-exchange order execution and those which are more liberal in this respect. In some Member States which enforce a concentration rule, spreads are as high or higher than spreads in Member States which do not.

Regulatory arbitrage:

Trading through multilateral trading facilities (MTFs) and off-exchange order execution by investment firms can reduce the volume of transactions finalised through the order-book of an exchange. Inevitably, this has prompted the question of whether new trading entities should be able to compete with exchanges for order-flow without incurring comparable regulatory overheads. In particular, should broker-dealers which internalise large volumes of client orders - and which on this basis are sometimes portrayed as assuming the role of "market-places" [21] - be asked to comply with exchange-type regulation? The answer to this question requires an objective assessment of whether it is correct to assimilate in-house execution with the operation of a marketplace. It further requires an understanding of how different regulatory requirements need to be adapted to the mechanics and risks of different methods of trade-execution.

[21] Euronext (2002): Internalisation. "Large financial conglomerates that already act in various capacities are setting their sights on another role which will enable them to expand their activities. After performing the role of stockbroker, market marker, analyst and portfolio manager, they now want to start playing at being exchanges." (p.12). cf. also A. Murray (2002): Key issues facing European securities exchanges. ("the increasing ability of banks to act as quasi-exchanges.." (p.17).

II.2. Guiding principles for regulating trade-execution:

ISD revision represents a unique opportunity to define the rules of the game so that order-execution - whether conducted on regulated markets, through MTFs or via off-exchange transactions by investment firms - is undertaken in a way which serves investor interests and the overall efficiency of the financial system. The way in which these issues are resolved will also have an important and direct bearing on the competitive relationship between different sets of market participants. In developing its response to the above issues, and deciding a balanced approach to the different regulatory trade-offs, the Commission has been guided by the following principles:

1). ISD revision should create the foundations for an integrated and competitive trading infrastructure. A fully integrated financial market is one in which buy and sell interests in a given financial instrument can interact seamlessly and instantaneously across EU-borders irrespective of the location of the market participants or the systems/means through which trading interests are expressed. [22] In this regard, national "options" concerning the handling and execution of retail investor orders - which account for some 90% of the number of transactions, but only 10% of value - are fundamentally at odds with the objective of a single financial market. They create a fault-line not only in terms of the regulatory and competitive situation of trading platforms in different Member States, but also in terms of the regulation of intermediaries, and protection to be offered to investors. If a revised ISD is to pave the way for an integrated and efficient financial market, it must - above all else - resist the siren call of an opt-in/opt-out approach to market regulation. In view of its potential to hinder the alignment of market regulation on a common model the proposal does not envisage the renewal of the "concentration rule" option.

[22] [The London Economics research identifies important reductions in spreads adverse price impacts that can be expected if EU equity and corporate markets are pooled, and suggests that this will generate non-negligible reductions in the cost of equity and corporate bond finance].

2). ISD should respond effectively to demonstrable risks to investor protection and market efficiency. The emergence of a more heterogeneous and complex trading environment calls for a proportionate response from regulators if investor interests and overall market efficiency are to be safeguarded. Investors must have confidence that brokers actively exploit new trading opportunities in order to obtain the "best deal" on client's behalf. Client interests must not be adversely affected by the existence of conflicts of interest when they rely on broker-dealers to execute their orders. Market professionals, issuers and regulators have a shared interest in ensuring that liquidity is not fragmented into shallow and disconnected pockets.

These concerns require the introduction of a package of measures to ensure that the dispersal of trading across multiple marketplaces and through diverse trading channels does not fragment liquidity and prevent market participants from identifying mutually advantageous potential trades. At the heart of this package is an effective transparency regime which seeks to ensure that appropriate information regarding the terms of recent trades and current opportunities to trade at all marketplaces, trading facilities and other trade-execution points is made available to market participants on an EU wide-basis. The proposal will also introduce enhanced obligations to ensure that intermediaries make active use of this information so as to get the best deal for their clients. [23]

[23] The proposed transparency rules seek to create the conditions in which traders and intermediaries are able to identify the trading arrangements which offer the best terms for transacting a trade in any given equity instrument and to move liquidity in response to price differences. This will allow orders to be executed at the venue which offers price improvement or best outcome for the end-investor, and assist the overall market system in converging on a price that reflects the full extent of price-relevant information across the entire market.

The proposal also recognises that brokerage clients should be allowed to express any preference that they may have as regards the channels through which their order may be executed. Information which may be relevant to the choice of broker or perception of quality of execution-service should be provided up-front so as to allow the client to make an informed judgement. To this end, it is proposed that the retail investor should give its prior consent, either on a general or on a trade by trade basis (see 3.5), before its orders are executed elsewhere other than on a "regulated market" or Multilateral Trading Facility.

3). ISD rules should be proportionate and work with the grain of the market:

Market efficiency and investor protection objectives should be pursued through regulatory interventions which constitute a proportionate response to demonstrable risk. They should take account of technology and market-based remedies, and impose as little restriction on competition and innovation as possible. This philosophy has informed the proposal in the following ways:

- "No prohibition" .... - ISD revision should not prohibit or otherwise impede, through application of unjustified or inappropriate regulatory requirements, order-execution outside traditional marketplaces/exchanges. Competition from new trading places [24] has spurred exchanges to innovate and develop new sources of competitive advantage. There is no reason to believe that these benefits have now been exhausted or that regulatory road-blocks should be erected to create captive order-flow for a certain category of marketplace.

[24] Competition from SEAQ forced many continental exchanges to revolutionise trading methods and systems in early 90s. Fear of competition from TradePoint led LSE to introduce SETS order-book trading in 96.

- No compulsion: The proposal will not require an entity to be licensed as a "regulated market" in order to undertake order execution on an organised basis. "Multilateral trading facilities", which operate trading interest display and execution systems, will be allowed to operate these systems on the basis of an investment firm licence subject to compliance with customised regulatory requirements (see below).

- No-one size fits all framework: Differences in regulatory treatment should not undermine the ability of institutions/exchanges, operating subject to a particular regulatory regime, to attract liquidity. However, limiting regulatory arbitrage does not amount to a case for blanket application of exchange-type regulation to other systems of methods of executing investor orders. Instead, ISD revision should establish comparable regulatory requirements for comparable order-execution methodologies. On this basis, multilateral trading facilities, which mimic exchange functionality for display and interaction of trading interests, will be subject to a variation on exchange-type rules for trading functions. [25] However, trade execution by investment firms when dealing or providing services to clients should not be equated with the operation of an organised market/order-book. The business, mechanics and regulation of multilateral trading systems and markets is fundamentally different from that of trade-execution by investment firms - even when the latter are internalising client orders. In particular, internal execution of client orders does not allow clients to trade at their discretion with other clients through systems operated by the investment firm. Furthermore, any transparency rules for quote-based dealing should not make it impossible for dealers to placing proprietary capital at risk in a manner that may improve market liquidity and smooth market functioning. ISD revision must, therefore, strike a careful balance between concerns relating to regulatory arbitrage and the need to allow liquid providers sufficient margin to operate. It is not a question of opting in favour of one type of one market structure at the expense of the other (order-driven versus quote-driven). The proposal seeks to create a regulatory framework which supports the co-existence of different trading channels, subject to the necessary safeguards for overall market efficiency and the interests of end-investors.

[25] To the extent that MTF are not vested with regulatory/self-regulatory responsibilities for screening the "quality" of instruments traded on the system, ATS need not be subjected to "regulated market"-type obligations on admission of instruments to trading.

In the light of the above considerations, this proposal seeks to establish a coherent and risk-sensitive framework for regulating the main types of order-execution arrangement currently active in the European financial marketplace. It proposes proportionate regulatory interventions to contend with the specific investor protection and market efficiency risks associated with each of the different trading methodologies. It addresses the competitive and regulatory interactions that arise when different trading platforms and methods exist alongside each other but subject to different permutations of market and investor-facing regulation. It aims to create a situation in which trading interests, regardless of the medium through which they are expressed or where they are located in the EU, are able to interact with each other on a cross-border basis in real-time so that liquidity is fully responsive to price-differentials.

Central to realisation of these goals is a comprehensive set of rules requiring transparency of trading information. This regime encompasses all main categories of execution method for equities transactions - regulated markets, MTFs, and off-exchange execution by investment firms. These transparency obligations aim to allow the effective, real-time, cross-border interaction of trading interests without which a single financial market cannot be said to exist. This regime will also permit competition and innovation in trade-execution, or services which include trade-execution, without jeopardising efficient price-formation. It will do so in a manner that promotes the disclosure of as much trade information as is possible, taking account of the fact the same degree of transparency is not suitable for all business models. This transparency regime will be an important guarantor of the fairness and efficiency of EU financial markets, and of investor access to the best deal for the size and type of trade that they are considering. It is not the only guarantor.

The proposal also envisages a range of other actions to ensure that off-exchange execution of client orders takes place only where it can be demonstrated to be in the best interests of the client. A particularly important feature of the proposal is the emphasis placed on enforcement of a more active and dynamic form of "best execution" obligation to ensure that investment firms consider a wide range of trading opportunities when trading on behalf of their clients. The proposal envisages a reinforced "best execution" obligation which will force investment firms to undertake a regular assessment of which execution venues represent offer the most favourable terms for transactions, and to be able to demonstrate that it is making use of those venues on behalf of its clients. This "best execution" obligation is the mechanism which will ensure that trading information made available under transparency obligations results in changes to the order-routing decisions of investment firms. In this way, it will ensure that competition between trading venues translates into price-improvement for the end-investor. It will also help to ensure that liquidity flows to the most efficient trading points. At present, liquidity in Europe tends to be very sticky and continues to be concentrated on the market of first listing [26] - even where there are reasons to believe that alternative trading venues may offer better prices. Whilst there is no directly comparable experience of using "best execution" to inter-link the range of competing trading venues that co-exist in Europe, new "smart order routing" applications are now available in the market place which will enable investment firms to monitor prices and depth across all EU exchanges and other principal trading venues.

[26] ECB survey or European equity markets, August 2001.

Taken together, these proposals constitute an important step towards a regulatory regime for an integrated, efficient and investor-friendly EU financial market. The key elements of the concrete proposals as they relate to the 3 main categories of trade-execution format currently active in the EU marketplace will be briefly presented.

II.3. High level principles for regulated markets (title III):

The proposal preserves the particular status and authorisation regime for regulated markets which is at the heart of the existing ISD, and is now firmly entrenched in all Member States securities rule-books. A "regulated market" comprises not only a trading venue where the negotiation and exchange of financial instruments is organised under a set of rules which embody different kinds of trading features. It is more than that: : it encompasses a broad set of functions, represents a distinct organisational form, and embodies particular trading features. [27] Admission of an instrument to trading on a "regulated market" also serves as trigger for the application of provisions of a number of related legislative measures. In recognition of these considerations, the ISD treats the operation of a "regulated market" as an activity warranting a separate regulatory regime.

[27] Some of the principal particularities of "regulated markets" when compared to a pure trading facility include the following: "regulated markets" have assumed an important role in vetting the quality of instruments admitted to trading/the public quote. The continued role of regulated markets in verifying the conformity of securities/instruments with rules governing the constitution and issue, provides a "quality labelling" for instruments which are publicly traded. Only marketplaces which are willing to assume these obligations should have the possibility of authorisation as a "regulated market". "Regulated markets" involve a distinct organisational form: they have assumed much autonomy and self-regulatory role in vetting members and policing activity on the market. "Regulated markets" also embody particular trading features: they guarantee efficient finalisation/settlement of transactions executed on the markets - although pure trading systems may also offer this level of functionality.

The existing ISD establishes a limited number of legal features that should be respected by all EU regulated markets. These embryonic elements are not sufficient to represent a common basis for the regulation/supervision of the principal EU financial trading venues. regulated markets are now becoming increasingly European in terms of the investor base, membership and range of instruments admitted to trading. Market conditions on one "regulated market" will henceforth have instantaneous and important repercussions for trading and market participants in other markets. [28] Against this backdrop, the absence of a common regulatory template risks presenting a significant impediment to the objective of an integrated, efficient and orderly trading infrastructure.

[28] Already have been episodes which highlight the high levels of inter-linkage between EU stock-markets. Earlier this year, trading error on DBAG stoxx index led to immediate and important disruption for trading of same index on other EU markets - but also for trading in substitute stock indices.

The proposal requires Member States to impose certain specified obligations on the "regulated market", which it shall fulfil under the supervision of a designated competent authority. The latitude given to the "regulated market" to design its trading rules, access conditions and reliance on it as a first line of defence for surveillance of trading on its systems is in recognition of the proximity to trading and self-interest of the latter in maintaining the quality of business performed under its systems.

The ISD proposal therefore seeks to establish a common set of high level principles authorisation, regulation and supervision of regulated markets so as to:

- identify the competent authority and applicable law (article 33): the proposal seeks to eliminate uncertainty as regards the relevant competent authority under whose exclusive jurisdiction the activity of the "regulated market" will fall. This will prevent scope for jurisdictional conflict or legal uncertainty which could have deeply damaging consequences for the legal finality of business done on the market;

- introduce requirements relating to the operator of the market (article 34): This provision requires the management personnel to be fit and proper, and to be endowed with financial resources needed to ensure the orderly functioning of the financial market. Once recognised as being in compliance with this provision, the market operator will be entitled to operate an MTF ", without having to obtain an additional authorisation to operate such a facility. The fitness and properness of the market operator and the resources at its disposal should also be taken into account if the market operator of an already established Regulated Market wishes to establish a "regulated market" in another Member State;

- define organisational requirements for the "regulated market" so as to ensure its fair, orderly and transparent operation. Relevant provisions in this regard include article 36 (trading rules) and article 39 (access of participants to market);

- establish comprehensive pre and post-trade transparency obligations to apply to orders/quotes displayed in the market and details of completed trades in equity transactions;

- pre-trade transparency (article 41): order-driven systems will be required to make public a part of their order-book. In quote-driven markets, designated market-makers will be required to publish an indication of bid/offer prices for some specified quotation size(s). The range of orders/quotes to be disclosed will be defined under comitology. In view of the fact that requiring display of orders/quotes of large sizes or in illiquid securities may deter market participants from bringing trades to the regulated market, these obligations shall not be applicable to such trades;

- post-trade transparency (article 42): regulated markets will have to make public the price, volume and time for all trades in equity instruments concluded under the rules and systems of the market on a reasonable commercial basis. Deferred reporting of trade details will be permitted for trades of large size and in illiquid securities.

- Admission of instruments to trading (article 37): this provision sets the high level principles under which a "regulated market" can admit instruments to trading on its systems, while allowed the detailed implementing measures to give effect to these principles to be developed at level 2. In brief, the "regulated market" should implement generic admission requirements, which have received prior public approval and which aim to ensure the free negotiability and effective settlement of instruments. The minimum conditions which instruments should fulfil in order to meet these requirements will be clarified at level 2. This clarification allows for differentiation between products admitted to trading on different market segments and is not intended to prevent regulated markets from applying more demanding admission requirements to its market segments. Article 37 also seeks to create a legal context in which regulated markets are able to admit to trading instruments which have been constituted and issued in another jurisdiction and where the market has taken steps to verify that the issuer is in compliance with its initial and other ongoing disclosure obligations.

- Suspension and removal of an instrument from trading (article 38): this provision foresees circumstances and conditions under which the competent authority or the Regulated Market can to suspend or remove an instrument from trading. It also establishes the framework for dealing with suspension or removal on a fragmented marketplace. When a competent authority decides to suspend or prohibit trading on an instrument, its decision shall be immediately applicable to all the trading under its jurisdiction (either on RMs, MTFs or OTC/internalisation). The competent authority will also have to inform about the suspension or removal to competent authorities in other Member States.

II.4. New core service for "Multilateral Trading Facilities" (MTFs):

The proposal envisages the introduction of a new core ISD service relating to the operation of an MTF. This will allow entities operating such systems to be authorised as an investment firm subject to a customised regulatory regime. There is a sizeable and growing population of these systems. [29] Their functionality does not correspond directly with the existing ISD services, and this has led to some uncertainty as to the appropriate basis on which to license and supervise these entities. The recognition of MTFs as a new category of investment firm is intended to clarify the nature of this business for the purposes of EU law, and to allow for the application of a common set of customised regulatory disciplines to deal with (market-facing) risks. [30] On this basis, MTFs will be able to make their facilities and services available to users throughout the EU on the basis of home country authorisation.

[29] In UK, some 29 entities are thought to fall within the scope of the MTF definition. DE is also home to a large number of these systems, while IT, BE, IRL, FR also have granted authorisations to MTF. These systems are active in a range of asset classes - particularly bonds and foreign exchange swaps but also equity. Experience from US suggests a period of consolidation (at least for bond systems) may follow the first phase of market development.

[30] A number of respondents have challenged the need to introduce a new authorisation regime for MTF. They argue that the activities of a MTF are adequately catered for by a combination of authorisation to provide "reception and transmission" and "execution" of client orders. The Commission does not concur with this analysis. The fundamental innovation represented by ATS is that they provide a non-exchange venue which users/clients can employ for dealing/trading at their discretion and for their own-account. This form of functionality means that MTF possess many of the features and give rise to the same regulatory issues as exchanges/marketplaces.

The proposed definition of MTF draws on the extensive analysis and 2 rounds of open market consultation undertaken by the Committee of European Securities Regulators (CESR). The proposed definition captures systems which support the multilateral disclosure of firm orders/indications of interest between the system users and the execution of orders resulting from the interaction of buy/sell interests expressed through the system. It also includes "auction-crossing" systems where user orders are executed against a reference price imported from outside the system. The common feature of these systems is that they support autonomous trading decisions by the system users, without there being any intercession of the system operator to facilitate trades or participate itself (against a proprietary trading book) in transactions with system users. There is no active or discretionary role of the system operator in pre-selecting, recommending or otherwise bringing together of trading interests. The system supports and facilitates direct user interaction with other system users. This form of functionality means that MTF possess many of the exchange-kind features and give rise to some of the same regulatory issues as regulated markets. For this reason, the proposed regulatory treatment under revised ISD focuses on the fair, orderly and transparent organisation of trading through the system.

The proposed MTF obligations are modelled on the market-facing principles which apply to the trading system functionality of regulated markets. These obligations are also heavily informed by the recently published CESR standards for "Alternative Trading Systems". The key provisions of the proposal concern:

- Organisational requirements for MTF (article 13): MTF will be required to apply transparent and objective commercial criteria in admitting its users. The potential user base for MTFs comprises market participants who are willing to trade at own risk and without the benefit of agency protections. In addition, the provision lays down obligations to ensure the objective, fair and expeditious handling of trading interests expressed through the MTF;

- pre and post-trade transparency obligations in respect of equity transactions concluded on MTFs (articles 27 and 28): the basic obligations are aligned with the level of transparency foreseen for trading interests in equity transactions when concluded or displayed through a "regulated market". Possibilities for deferral of trade reporting, and the range/depth of pre-trade disclosure will be similar to those required of regulated markets. Auction-crossing systems and other types of MTF which do not involve prior disclosure of firm indication for prices may be exempted from the scope of the pre-trade transparency obligation;

- waiver from agency obligations for transactions concluded on the MTF (article 22): Users of the MTF are professional or active market participants trading on their own account and at their own risk and capable of assuming responsibility for their investment decisions. They do not expect the operator of the MTF to offer them agency protections. Consequently, conduct of business and other investor protections will not be relevant to the type of trading conducted through an MTF. In view of this, the proposal foresees that MTF will be required to limit participation to "eligible counterparties". The proposal does not envisage forcing MTF to admit freely non-system users for the purposes of trading against a bid or offer which is publicly displayed pursuant to article 27.

- Right for MTF to place screens in other Member States (article 29): In parallel with the provision allowing regulated markets to place trading screens or operate other arrangements to enable remote members located in other Member States to have access to and trade on the "regulated market", it is proposed to recognise a similar right for investment firms operating MTFs under the free provision of services.

In order to ensure that this new category of investment firms has provisioned for relevant risks arising firm its activities, they will be required to hold initial capital and an additional amount of own funds in accordance with Directive 93/6/EEC (CAD). Capital requirements and endowment shall take account of relevant regulatory developments in the EU and other international for a, particularly those pertaining to capital charges on operational risk.

The proposal does not consider adequate to establish mandatory admission requirements for the instruments traded at the MTF. The MTF is a pure trading functionality where its participants may decide what specific financial instrument to trade. However, when in the systems of an MTF is traded on a regular basis an instrument that is also traded in a "regulated market", the MTF should take the necessary steps to verify the compliance of the instrument/issuer with the relevant provisions of Community law (i.e. disclosure).

II.5. Trade execution by investment firms:

The proposal envisages a systematic modernisation of the obligations incumbent on investment firms when they execute transactions outside the rules and systems of a "regulated market" or MTF. This review has been prompted by two distinct considerations:

- to contend with particular concerns relating to the possible conflicts of interest which arise when integrated houses (broker-dealers) execute client orders internally;

- to provide an effective and proportionate response to concerns that off-exchange order execution by dealers and broker-dealers may undermine efficient price-formation, and in doing so, potentially weaken "best execution" policies.

Conflicts of interest in (internalising) broker-dealers:

The debate surrounding "internalisation" has thrown into sharper relief the already commonplace conflict of interest that arises when investment firms cumulate the functions of broker and dealer. [31] Execution of client orders against the firms' proprietary positions begs the question of whether investors can be confident that their interests are paramount when the broker-dealer acts on their behalf. [32] These concerns are exacerbated where an investment firm implements systems and procedures to maximise the number of client orders executed against proprietary positions or other client orders.

[31] The revised orientations, published as a basis for open consultation in March 2002, envisaged a distinction between entities which systematically internalise client orders and those which do so on an incidental basis. A quantitative threshold (10% of client order flow internalised over preceding 4 quarters) was proposed as basis for dividing line. This distinction has been widely criticised on 2 counts: first, the rationale for the distinction is unclear. Internalisation implies a conflict of interest between client and broker/dealer interests irrespective of the scale of internalisation. Secondly, the proposed threshold was condemned as being unworkable, and resulting in different market consequences across large/small national markets. In view of these cogent criticisms, the Commission proposal abandons this distinction and seeks to create a general regulatory framework within which conflicts of interest related to all internalisation activity can be managed.

[32] Market structures where the client brokerage function and the dealing against client order are functionally separated, or undertaken by different entities do not give rise to the basic conflict of interest at issue. The Retail Service Provider regime in operation in the UK whereby a retail broker routes client orders to a different entity for execution against a proprietary position of the latter would not be considered "internalisation" in the sense of this proposal.

The assessment of the need for additional checks and balances on investment firm trade execution must take account of the range of investor-facing obligations with which investment firms must already comply, and which circumscribe the manner in which an investment firm can execute client orders. "Best execution" requirements, in particular, mean that the investment firm does not have unlimited discretion about how it executes orders on behalf of clients. However, the Commission considers that existing disciplines for investor protection must be significantly tightened in order to contend with the possibility that conflicts of interest in integrated broker-dealers operate to the detriment of their clients. The ISD proposal seeks to place proportionate and effective safeguards on a definitive and firm legal footing. In particular, it is proposed to:

- introduce a new self-standing provision on conflict of interests covering, inter alia, those that arise in integrated broker-dealer houses (article 16). This provision seeks to ensure that the investment firm is organised so that client interests are not adversely affected by conflicts of interest between the brokerage and dealing business of the firm. Broker-dealers will be required to identify, prevent or otherwise manage conflicts of interest so that they do not adversely affect clients interests. Legally binding implementing measures which specify the types of administrative and organisational arrangements that broker-dealers need to introduce will be developed at level 2;

- reinforce "best execution" obligations (article 19): the investment firm will be obliged to be able to demonstrate that it has made best endeavours to obtain the best deal for the client. This obligation limits the possibilities for internal execution to situations where this matches or betters the terms at which the client order could be finalised on a "regulated market" or in the wider market.

- establish client order-handling rules (article 20): these rules will ensure that client orders are processed expeditiously and according to objective rules of precedence and priority. These stipulations seek to ensure that the investment firm takes active steps to facilitate execution of the client order, and that the client's interests are not adversely affected by self-interested or negligent handling by the firm. In addition, it is proposed that client limit orders, which the firm is not in a position to execute itself at the specified terms, be traded into the wider market.

Off-exchange trade execution and efficient price formation: [33]

[33] The reasoning underlying this section has been developed more extensively in a related working paper of the Commission services, in order to do justice to the many complex facets of the debate.

Transparency rules are the principal means through which it is proposed to safeguard the efficiency of price formation and sustain "best execution" in an environment where trade-execution is being performed on a range of markets and systems throughout the EU. Quotes offered and details of off-exchange trades completed by investment firms may also embody information which is relevant for the valuation of instruments by other market participants. A critical issue is therefore to what extent and in what form should transparency obligations be imposed on off-exchange trade-execution by investment firms. The basic presumption is that pre and post-trade transparency rules should apply to off-exchange trade execution by investment firms unless other considerations - trade-off with liquidity provision, compliance costs - outweigh any benefits. The following sections set out the conclusions of the Commission on whether and/or how ISD should impose transparency obligations on investment firms.

(a). Post-trade transparency obligations (article 26):

Against the backdrop of global competition between markets and trading systems and the growing preponderance of parallel trading in blue-chip securities, post-trade transparency obligations can play an important role in reconstituting liquidity and inter-linking different trading venues. Swift publication of price and volume details in respect of completed trades will allow professional market arbitrageurs to shift liquidity in response to observed bid/offer prices at different trading venues. Transparency rules which overlook the sizeable and growing volume of off-exchange/MTF trading will, by definition, be partial in scope and sub-optimal in effect.

It is therefore proposed to introduce an obligation for all investment firms concluding trades in equity instruments (once these are admitted to trading on a "regulated market") to disclose publicly, as close to real-time as possible, the price and volume of completed trades. Possibility of deferred reporting for large trades or trades in illiquid equities is foreseen in order to allow traders to unwind large positions before the existence of their exposure is made known to other market participants. By allowing for deferred reporting of large trades, the proposed post-trade transparency rule avoids exposing proprietary trading positions and limits any conflict with liquidity provision.

Investment firms are afforded considerable flexibility as to the arrangements through which they comply with this obligation. A base-line obligation is that they report the details of completed off-exchange trades to any "regulated market" of which they are a member (and with which they will already have established 2-way data feeds). Such links, once established, can allow investment firms to report trades at low cost. [34]

[34] LSE charges 2p for filing of each off-exchange trade reported to it by its members.

(b). Pre-trade transparency obligations:

In preparing the proposal for revision of the ISD, the Commission services have given careful consideration to the imposition of pre-trade transparency obligations on off-exchange transactions of investment firms. The reason for contemplating such an obligation stems from the basic presumption that maximising the flow of trading information to market participants will enhance the price-formation process. Judged from the perspective of "best execution" or efficient price-formation, it is not enough to know the conditions under which the last trade was concluded. The fact that a particular execution-point represented the best deal for the last trade provides no guarantee to market participants and investors that it will also offer the best terms for the next deal. Judged against the benchmark of an absolute" best execution" obligation, market participants and investors could benefit from access to information on all current trading opportunities - not only those available on regulated markets and MTFs. Investment firms, in processing of investor orders or by publishing quotes to other market participants, may possess or generate information which could also influence the overall market valuation of given instrument.

However, given the fundamental differences between bilateral dealing or order-execution by investment firms and exchanges, pre-trade transparency obligations designed for regulated markets and MTFs cannot be directly extrapolated to dealers and broker-dealers. Trading interests expressed through a public order-book are knowingly disclosed to other market participants. This allows wider disclosure of those trading interests to be mandated without undue concern about any potential consequences for proprietary positions of market participants. The same is not true of dealers whose ability to undertake their business is inextricably bound up with their ability to make quotes on a selective or discretionary basis. It would be counterproductive from the perspective of liquidity provision, to compel investment firms to disclose extensive details of their trading book to the wider marketplace.

In view of these considerations, the Commission proposes to introduce pre-trade transparency requirements for investment firms in the form of a client limit order display rule (article 20(4)) and a quote disclosure rule for retail size orders in shares (article 25).

The client limit order display rule will require the investment firm immediately to make public client limit orders which it is unable or unwilling to execute itself at the specified price. Limit orders are a particularly powerful price-signal because they specify clearly the precise value which that investor attaches to the transaction. In certain marketplaces limit orders are becoming a normal or event the predominant form in which investor orders are expressed. Some 62.9% of orders for small transactions of less than 5000 shares in CAC 40 stocks on Euonext Paris (in September 2001) were expressed in the form of limit orders. This proportion increases as the size of the transaction increases. [35]

[35] M. Auguy and D. Davydoff, the European Market model, July 24. 2002.

The client limit order display rule will ensure that investment firms do not withhold price-relevant information - embodied in the terms of a non-executed client limit order - from other market participants. The rule seeks to ensure that this information is made public in a way that the relevant information is immediately and easily visible to other market participants and the marketplace as a whole. The rule allows the possibility for non-disclosure of limit orders in respect of large transactions or where requested by the client. The rule would also not prevent the investment firm from concluding the transaction in-house as long as this is done immediately so as to offer the benefits of fastest and most expedient execution to the client, and subject to the express prior consent of the client. Given the growing preponderance of limit orders, and their importance as a source of price-relevant information, the client order display rule represents an important safeguard for overall market efficiency.

In addition, the Commission proposes to introduce an obligation for investment firms which operate a trading book to make public a bid and offer price for a specified transaction size for the most liquid shares (a "quote disclosure" rule). This provision reflects the basic presumption in favour of maximising the volume of trading information. The overall price formation process and the effective enforcement of "best execution" will be enhanced if (large) dealers and broker-dealers are required to advertise the terms at which they are willing to conclude transactions.

Such a rule will provide other market participants with some indication of the terms on which the investment firm stands ready to conclude transactions for the specified transaction size in the share in question. This will expand information on current opportunities to trade, and allow even greater number of execution possibilities to be considered for "best execution". In the case of broker-dealers which internalise client orders, it will require those firms to disclose some prior indication of the terms and conditions at which they are able to match client "market orders" (orders for execution at the best available price).

As explained previously, a quote disclosure rule should avoid over-exposing the positions of dealers to the extent that they are unable to trade positions at a profit, and lose the incentive to act as a permanent point of liquidity in the market place. However, a review of theoretical and empirical material of the US experience suggests that the concern that pre-trade transparency will impede liquidity provision seems only to be borne out for transactions which are large in size or in illiquid securities. An appropriately calibrated pre-trade transparency rule does not seem to hinder dealers and market-makers from continuing to provide liquidity support to the market on a profitable basis. The SOES ("small order execution system") rules operated by the NASD provide a working example of how quotation rules can be designed which stipulate specified quotation sizes to be displayed, and which take account of different levels of liquidity in the stocks concerned [36]. Moreover, US experience suggests that quote disclosure may enhance trading volumes and overall market liquidity at the displayed bid/offer and quote sizes. In the light of US experience with quote disclosure rule, it is proposed that mandatory quote disclosure should be confined to retail-size transactions in highly liquid equities. In this way, it should not constitute a significant impediment to proprietary dealing by banks.

[36] NASD rule 4710: rules of practice and procedure for the small order execution system. Cf. NASD manual pp. 2303-2308 and NASD notice to members 97-90 on changes to SOES tier-size levels Dec. 97)

The introduction of a quote disclosure rule will impose some compliance costs on investment firms as regards the publication of quotes. In particular, they will have to ensure that the mandated bid and offers are visible and accessible to market participants on a continuous and real-time basis - preferably through systems which consolidate quotes from as many investment firms as possible. These costs will be minimised through appropriate specification of the scope of the obligation and the reporting methods. The proposed quote disclosure rule also allows for small dealers, which are unlikely to be significant contributors to liquidity or price-formation for shares, to be exempted from the scope of the obligation.

II.6. Conclusions on the regulation of trade execution:

The proposed Directive for revision of the ISD seeks to create a regulatory framework in which obligations are tailored to the specific risk-profile of different market participants, and which takes account of competitive and regulatory interactions between different trading formats so as to maintain overall market efficiency. The following table summarises the salient features of this regulatory regime.

Table: Synopsis of regulatory framework for different methods of trade-execution.

>TABLE POSITION>

Section III. Investor protection and the investment firm regime (title ii):

The proposed Directive will harmonise the initial authorisation and operating conditions for investment firms established in the EU. The relevant provisions embody a high level of protection for investors/clients which rely on investment firms for advice, to intervene in the market on their behalf, or to manage their personal investment portfolios. Clients of such firms should be confident that duly authorised firms, wherever authorised in the EU, will act diligently and in their best interests. To the extent that these conditions are established, duly authorised investment firms should be able to provide services to clients in other Member States on the basis of their home country authorisation and ongoing supervision by their domestic competent authority.

The provisions of the existing ISD are not sufficient to serve these twin objectives:

- the investor protection disciplines of the existing ISD are outdated. They do not provide sufficient leverage over the manifold conflicts of interest that arise when investment firms perform a wider range of client-oriented and own-account activities under one roof. They do not create effective obligations for investment firms to make use of the increased array of order-execution facilities for their clients. The current proposal envisages a systematic overhaul of the provisions relating to authorisation and ongoing supervision of investment firms so as to rectify these deficiencies;

- the existing Directive does not establish the bed-rock of harmonised investor protection obligations needed to support mutual recognition of authorisation and operational requirements. A combination of overly generic principles, unsupported by operational guidance and undermined by ample provision for "general good" derogations, has limited the ability of investment firms to exercise their Treaty freedoms on the basis of home country supervision. In revamping the ISD, it is proposed to enshrine a high level of investor protection and on this basis to clarify that investment firms providing services freely in other Member States shall operate subject to control only of their home country supervisor. [37]

[37] Host authorities shall be notified of the operation of partner country firms on their territory through the existing notification mechanism, have the possibility to request the home authority to intervene, and to intervene itself as a precautionary measure where circumstances demand it.

To remedy these deficiencies, the proposal envisages a far-reaching modernisation and reinforcement of the obligations that investment firms must comply with when providing services to clients or acting in the marketplace, as well the rights to which investment firms are entitled by virtue of ISD authorisation. The relevant provisions encompass:

- conditions for initial authorisation, including organisational requirements (articles 4-14):

- general operating conditions including conflict of interest identification and management (articles 15-17);

- obligations of investment firms when providing services to clients, including conduct of business rules, best execution obligations and client order handling rules (articles 18-22);

- requirements to uphold market efficiency and integrity including transparency obligations (articles 23-28);

- provisions governing the rights of investment firms (articles 29-32).

The most substantive adjustments to the content of key investor protections are presented in this section. The obligation for investment firms to comply with transparency obligations for off-exchange transactions has been discussed extensively in the previous section and will not be presented again.

III.1. Capital adequacy (articles 11 & 17):

As under the existing Directive, compliance with the initial and ongoing capital requirements, as laid down by Directive 93/6/EEC, is a pre-condition for authorisation and operation as an investment firm.

The proposal for ISD revision envisages modification of the Capital Adequacy Directive to clarify that investment firms which provide only the service of investment advice shall be exempted from obligation under the Capital Adequacy Directive. This clarification is achieved through art. 62 which proposes to add a 4th indent to Article 2(2) of 93/6/EEC which clarifies that investment firms which are authorised to provide only the service of investment advice are not to be regarded as investment firms for the purposes of CAD. This special treatment of investment advisors for the purposes of the capital adequacy Directive is in addition to the existing exemption for investment firms which receive and transmit client orders without holding money or assets on their behalf.

A special treatment with respect to capital requirements can be justified by the fact that these entities do not represent a source of counterparty or systemic risk to other market participants, and that clients are not exposed to the risk of direct loss of funds and assets when dealing with advisors. The main regulatory risk associated with this activity is the legal/operational risk that could arise from failure to respect "due diligence" when providing investment recommendations to individual clients. The proposal envisages the introduction of obligation to hold professional indemnity insurance to contend with these risks and to allow the firm to meet any damages owed to clients awarded compensation resulting from inadequate performance of these activities. This obligation, and the amounts of professional indemnity insurance cover to be held are based on the corresponding provisions of the Directive on insurance Mediation.

In the context of the ongoing review of capital requirements, the Commission is developing proposals which will change the current regime. In so doing, the Commission will have full regard to the situation of low risk investment firms, including investment advisors.

III.2. Conflicts of interest (article 16):

It has become imperative to create a self-standing provision of the ISD to govern the expanding range of circumstances in which the various interests of the investment firm, its managers and employees may conflict with those of its clients. The expanding range of activities that many investment firms and banks undertake under one roof by has increased potential for conflicts of interests between these different activities and those of clients. This is allied to the greater prevalence of inducements, and well-established concerns relating to conflicts between clients. The patchy treatment of conflict of interests under the existing ISD does not allow for a coherent or effective response to these matters which are critical for the defence of clients.

The introduction of a separate provision which allows for the elaboration of detailed implementing measures through comitology, will allow regulators to react in a concerted and tailored way to types of conflict of interest which warrant particular attention. This would for example allow for targeted interventions in respect of conflicts arising from, for example, the accumulation of financial analysis/research and brokerage or underwriting/placing activities, or client order execution by broker-dealers.

The proposed provision establishes an obligation for investment firms to, first, identify conflicts of interest that arise in their business activities which might prejudice the interests of their clients. Investment firms would then be required to either:

- Prevent those conflicts of interest from adversely affecting the interests of clients; or

- establish organisational and administrative arrangements which allow them to manage these conflicts of interest in such a way that the interests of clients are not adversely affected.

The provision does not prescribe the nature of organisational or administrative arrangements that shall be considered appropriate for management of different forms of conflict of interest, or way in which conflicts of interest must be disclosed where relevant. The provision foresees that detailed implementing measures be adopted at level 2 to provide guidance on these points.

Where the firm has sought to manage conflicts of interest through the establishment of organisational arrangements but it cannot be ascertained with reasonable confidence that these conflicts of interests no longer potentially prejudice the interests of clients, the firm shall disclose the existence of these residual conflicts of interest to the client. Disclosure may, where appropriate or necessary, be generic.

III.3. Conduct of business rules when providing services to clients (article 18):

Conduct of business rules are one of the mainstays of investor protection. Implementation of the present provision has been hampered by a lack of clarity as to interpretation of the main operational concepts (professional/retail investor), ambiguity as regards the role of home and host authorities in enforcing these obligations, overlap with market integrity issues, and inclusion of unworkable tests ("look through"). The provision has been extensively reworked to update the rudimentary and ambiguous principles laid down in the existing Directive. conduct of business regimes. This revamping of underlying principles takes full account of the standards for investor protection which have recently been adopted by CESR.

A key objective of this overhaul has been to allow the provision of clear and legally binding guidance on the implementation of the broad principles. To this end, the provision provides for the adoption of common conduct of business rules through comitology. It is provided that these detailed rules will differentiate in their application between investment services and between professional and retail clients who require different forms and intensity of agency protection. Annex 2 to the proposal sets out criteria and procedures for determining when a client can be categorised as a "professional client" for the purposes of applying the relevant light-touch conduct of business rules. This classification mechanism is based on the work developed by CESR in consultation with market practitioners. Detailed implementing rules will also be applied in a differentiated manner to investment or ancillary investment services and/or to different service formats (e.g. portfolio management and "execution-only" brokerage) or instruments.

In the event of branch operations, it is proposed that the host authority assume responsibility for enforcing conduct of business. The host authority is in greatest proximity to the branch and is better placed to detect and intervene infringements of firm-client transactional obligations. The management of firm-client business at branch level means that investment firms do not see any difficulty in cooperating with host authorities in this domain.

III.4 Best-execution (article 19):

An effective "best execution" obligation for investment firms can help to ensure that fragmentation of trading across diverse execution venues works to the advantage of clients rather than to their disadvantage. An active "best execution" policy will ensure that investment firms consider trading conditions on a range of trading venues, and make use of "smart" order-routing techniques in order to seek out the best bargains for their clients. In doing so, it will allow competition between brokers to drive improvements in execution quality to the benefit of the investor. This should result in improved brokerage services for clients compared to current practice whereby firms are only required to match the prevailing price on the local regulated market.

"Best execution" rules are also important from a broader market efficiency perspective. The operation of an integrated financial market requires that orders to buy and sell financial instruments interact effectively, freely and instantaneously with each other on a cross-border basis. Requiring investment firms to consider trading conditions on a reasonable range of execution venues, and to route orders to the venues offering the best prices, will ensure that liquidity responds quickly to price differentials. In this way, an effective "best execution" policy helps to ensure that liquidity flows to the most efficient and competitive trade-execution venues and serves as a guarantor of overall market efficiency.

Given these important considerations, a key feature of ISD revision is to establish a separate provision governing the "best execution" obligations of brokers/broker-dealers. The first element of the provision establishes the obligation for all investment firms acting on behalf of clients to exercise due diligence to ensure that the order is executed in the conditions that are most favourable to the client. It establishes a general benchmark against which the execution of client orders may be judged in a context where transactions in the instrument in question are potentially being concluded on a variety of marketplaces. This benchmark emphasises, in the first instance, the best net price to the client. However, allowance is made for other factors which may influence the optimal handling of the order such as the time and size of order. These considerations may be particularly re