While the concept of organized trading facilities has been introduced into Swiss law more than one and a half year ago, many of the rules applying to organized trading facilities will only be phased in by the beginning of 2018. Similarly, the Swiss regulator, the Swiss Financial Market Supervisory Authority FINMA, has only recently published regulatory guidance on the rules applicable to organized trading facilities. Such rules and regulatory guidance will start applying from January 1, 2018.

By Patrick Schleiffer / Patrick Schärli (Reference: CapLaw-2017-44)

1) What is an Organized Trading Facility?

With the enactment of the Financial Market Infrastructures Act (“FMIA”) and its implementing ordinance (“FMIO”) in the beginning of 2016, the Swiss regulatory framework applicable to trading platforms was significantly changed. Under the previous rules, Swiss law categorized trading platforms into exchanges (e.g. SIX Swiss Exchange, Eurex Zurich) and other trading platforms (referred to as “börsenähnliche Einrichtungen”). The latter category included all kinds of trading platforms that—while having similar functionalities than an exchange—did not meet all the criteria to qualify as an exchange. These other trading platforms were regulated on a case by case basis by FINMA with some platforms being essentially regulated like an exchange (e.g. BX Berne Exchange) and with other platforms not being regulated at all. Under the FMIA, trading platforms now fall into one of the following three categories: exchanges, multilateral trading facilities, and organized trading facilities (“OTF”).

Unlike under European law, the Swiss law OTF category serves as a rather wide catch-all category and encompasses the following types of trading platforms:

• Multilateral trading platform that allow for trading in securities within the meaning of the FMIA (i.e. standardized financial instruments which are suitable mass trading) and other financial instruments based on discretionary rules;
• multilateral trading platforms on which financial instruments other than securities (such as OTC derivatives) can be traded based on non-discretionary rules; and
• bilateral trading platforms. According to the recent FINMA circular on OTF (“FINMA Circular 18/1”), trading is considered bilateral if and when the operator of an OTF acts as counterparty and thus takes a market risk.

Conversely, under Swiss law, a multilateral trading platform on which securities (within the meaning of the FMIA) can be traded based on non-discretionary rules would have to be set up as a multilateral trading facility (“MTF”).

Under the FINMA Circular 18/1, trading rules are deemed to be discretionary if the operator of an OTF has discretion to place an order through, or withdraw it from, an OTF, or not to match an order with another order, or, in case of a bilateral trading platform, to enter or not enter into an agreement with its counterparty.

It is noteworthy that under Swiss law the activity of a so-called systematic internalizer would be captured as an OTF (more specifically, as a bilateral trading platform). The proper categorization of an OTF as a multilateral system or a bilateral system is important as the Swiss rules on OTF make a clear distinction between obligations that apply to multilateral OTF and obligations that apply to bilateral OTF.

Given the rather wide scope of the term OTF, FINMA Circular 18/1 also provides for regulatory guidance on what is actually considered an OTF and what falls outside of the scope of the term OTF. For example, FINMA Circular 18/1 specifically excludes e.g. bulletin boards, order routing facilities and indicative pricing facilities from the scope of application of the Swiss OTF rules.

2) Which Organized Trading Facilities Fall within the Scope of the Swiss Rules?

The Swiss OTF rules generally apply to all Swiss OTF, i.e. OTF that are (i) directly operated by a Swiss financial institution (i.e. licensed bank, securities dealer or financial market infrastructure), or (ii) operated by a non-Swiss operator and that has at least a technical presence in Switzerland (e.g. server infrastructure). Non-Swiss OTF that do not have a technical presence in Switzerland are not subject to the Swiss OTF rules. In our view this is also true where a non-Swiss OTF voluntarily seeks for a recognition from FINMA.

Further, where an OTF is operated by a Swiss licensed bank, securities dealer or a licensed trading venue through a non-Swiss branch or a non-Swiss subsidiary, such OTF is in our view also not subject to the Swiss OTF rules. However, in such a case, FINMA expects that the Swiss bank, securities dealer or trading venue has put in place appropriate measures allowing them to identify, monitor and mitigate the risks related to such OTF.

3) What Rules Apply to Organized Trading Facilities in Switzerland?

Unlike exchanges or multilateral trading facilities, OTF are not independently authorized financial market infrastructures. Rather, operating an OTF is an activity that is only open to certain already licensed financial market players. I.e., only Swiss licensed banks and securities dealers as well as authorized or recognized trading venues (i.e. operators of an exchange or an MTF) are permitted to operate an OTF in Switzerland.

While not being subject to separate licensing requirements, financial institutions that wish to operate an OTF have to comply with a specific set of rules, including organizational measures, prevention of conflicts of interests, guarantee of orderly trading and pre- and post-trading transparency. Also, FINMA has to be notified of the fact that an OTF is being operated or that the operation of an OTF is being contemplated in the future.

a) Organizational Measures

The Swiss rules require that an operator of an OTF puts in place adequate internal regulations allowing it to monitor trading operations and compliance with rules and regulations. For this purpose, the operator of an OTF must also keep a chronological record of orders and transactions carried out through its platform.

In addition, the FMIA stipulates the following three guiding principles regarding the organization of an operator of an OTF:

• The operation of the OTF needs to be separated from the other business activities of the OTF operator;
• the operator of the OTF must take effective organizational measures to identify, prevent, settle and monitor conflicts of interest; and
• the operator of an OTF must ensure that client interests are comprehensively protected when conducting proprietary transactions on the OTF.

The Swiss regulator FINMA has further specified these principles in its FINMA Circular 18/1. In this circular, FINMA also makes a distinction between rules that apply to multilateral OTF and rules that apply to bilateral OTF:

• Multilateral OTF: FINMA Circular 18/1 requires that operators of OTF not only separate the OTF part of their business from its other business activities, but that they also operatively separate multiple OTF (if such an operator runs multiple OTF) from each other. In particular, a transfer of orders between bilateral functions and multilateral functions must be prevented by putting in place appropriate and effective measures. Further, operators of OTF must avoid conflicts of interest by not carrying out own-account trading (bilateral OTF) and matched principal trading (multilateral OTF) on the same trading platform.
  Where the relevant OTF allows for transactions to be carried out based on discretionary rules, best execution must be guaranteed, provided the relevant platform participant has not expressly waived this right.
  FINMA further specifies what it considers to be “appropriate and effective measures” for achieving operational separation. According to FINMA Circular 18/1 such measures include the use of rooms, personnel, functions, organization and information technology to identify, prevent, eliminate and monitor conflicts of interest and to create confidential spaces in which information can be isolated and controlled. Further, FINMA expects that the persons who trade in securities or financial instruments or decide on such trading must not be allowed to make any decisions regarding the ongoing operation of the OTF.
• Bilateral OTF: While operators of multilateral OTF are subject to stringent operational separation requirements, FINMA’s focus is a different one when it comes to operators of bilateral OTF. Here, FINMA’s primary focus is transaction transparency and mitigation of potential conflicts of interests. More specifically, FINMA Circular 18/1 requires that operators of bilateral OTF must ensure that each order is executed at the price valid when the order was received or at a better price for the participant. In other words, the operator of a bilateral OTF must generally ensure that the best possible result is achieved for the participant financially as well as in terms of timing and quality. Exceptions from this best execution requirement are permitted if the relevant client has expressly waived its right to best execution for a specific transaction or issues clear instructions.
  Where an operator of a bilateral OTF creates specific financial instruments for its clients and then provides repurchase prices for such financial instruments, the OTF operator must ensure that the repurchase prices are reasonable in relation to the products’ underlying assets.
  The operator of a bilateral OTF must show to its participants, on request, that their orders have been executed in accordance with the rules established by the platform.

b) Guarantee of Orderly Trading

The FMIA subjects operators of an OTF to an obligation to guarantee orderly trading. More specifically, the FMIA requires that operators of an OTF must ensure orderly trading even in the event of intense trading activity and that the operator of an OTF must take effective measures to prevent disruptions to the trading facility. The FMIO further specifies that in order to ensure orderly trading, an operator of an OTF has to do the following:

• Set and implement transparent rules and procedures for fair, efficient and orderly trading, as well as objective criteria for the effective execution of orders;
• put in place measures to ensure the robust management of technical processes and the operation of its systems, including, (i) ensuring that its system has sufficient capacity to deal with peak volumes of orders, (ii) ensuring trading under conditions of severe market stress, (iii) having in place disruption recovery processes, and (iv) being able to reject, cancel, amend or correct certain orders and transactions or halt trading in case of significant short-term price movements;
• enter into written agreements with all of its participants holding a special function (e.g. market makers); and
• put in place effective measures relating to algorithmic trading and high-frequency trading in order to prevent disruption of trading on the OTF. This includes the capability to identify such transactions and requirements for participants to flag their transactions.

Pursuant to FINMA Circular 18/1 an operator of an OTF has to enact regulations on the organization of trading and monitor compliance with applicable rules and regulations. Operators of an OTF should further set up an efficient control function that is independent of trading and systematically records and evaluates trading data without interruption and must integrate this into its internal control system.

c) Pre-Trade Transparency

As described below, the FMIA provides for a post-trading transparency duty applying to OTF. Further, the FMIA empowers the Swiss government to also put in place pre-trading transparency obligations in line with internationally recognized standards. The Swiss government did so by including appropriate provisions in the FMIO.

For the time being, an OTF’s pre-trade transparency obligations only relate to shares. Other financial instruments, such as bonds, structured products, are not subject to the pre-trade transparency.

The pre-trade transparency rules apply to multilateral OTF and bilateral OTF with a liquid market. According to FINMA Circular 18/1, a market for a financial instrument is regarded as being liquid if the financial instrument in question was traded at least 100 times per trading day on average in the previous year on the trading venue (i.e. exchange or MTF) to which it was first admitted. Thus, if a financial instrument is not admitted to trading on a trading venue, no liquid market exists in such financial instrument for purposes of FINMA Circular 18/1.

Finally, under the FINMA Circular 18/1, a bilateral OTF can meet the pre-trade transparency requirements by publishing binding offers only. If no liquid market exists for a particular financial instrument, it is sufficient to provide price offers on request only.

d) Post-Trade Transparency

Unlike the pre-trade transparency, the post-trade transparency generally applies to transactions in all kinds of financial instruments conducted on an OTF. Like it is the case with other obligations, the Swiss post-trading transparency rules make a distinction between multilateral OTF and bilateral OTF:

• Multilateral OTF: As a general rule, the platform needs to but in place regulations and processes allowing for the publication of information regarding the price, volume and time of transactions as soon as possible. Transactions that were carried out outside of trading hours need to be published by the start of the following trading day. Publication delays are permissible in certain cases and if the platform has provided for such publication delays in its rules and regulations.
• Bilateral OTF: Bilateral OTF have lighter post-trading transparency rules. Here, it is sufficient to publish aggregated trade information at the end of each trading day.

4) When Do the Swiss Rules Start to Apply?

There are two different starting points for the obligations that apply to OTF. First, the organizational measures, including the prevention of conflicts of interests apply ever since the entry into force of the FMIA in the beginning of 2016. However, the regulatory guidance relating to these obligations as set out in FINMA Circular 18/1 will become effective only on January 1, 2018. Second, the rules regarding pre- and post-trading transparency, algorithmic trading and high frequency trading and most of the other aspects of the duty to ensure orderly trading (e.g. flagging of short sales, written agreements with special participants (such as market makers), technical measures (e.g. emergency measures, order rejection and the like), have to be complied with no later than January 1, 2018.

5) Conclusion

Operators of Swiss OTF will have to make sure that they are ready for complying with the various new rules that will be in full force and effect starting from January 1, 2018. More specifically, the OTF operators should review their regulation and update them accordingly in order to keep track of the various new obligations (e.g. with respect to algorithmic trading). Further, OTF operators need to review and, if necessary, adapt their internal organization in order to keep up with the additional organizational requirements (e.g. operational separation, control functions) that will be put on them starting from next year. Finally, OTF operators need to put in place appropriate processes to handle pre- and post-trade transparency. This includes enacting regulations and, on a more technical level, defining how and in what format data will have to be delivered and subsequently published.

Patrick Schleiffer (patrick.schleiffer@lenzstaehelin.com)
Patrick Schärli (patrick.schaerli@lenzstaehelin.com)