Bitcoin won’t be trading on the public exchanges just yet.

Says who?

Jay Clayton, Chairman of the Securities and Exchange Commission, that’s who. In speaking at the recent Delivering Alpha conference co-hosted by CNBC and Institutional Investor, Clayton said that until there is better regulation over the nascent crypto markets don’t expect any exchange-based trading. Until that happens, investors can continue to expect volatile price swings and liquidity issues.

With a market cap of approximately $177 billion, Bitcoin has seen a number of attempts to go mainstream, including using it to back ETFs that could attract not just retail but institutional investors.

Bitcoin currently trades around $8,240, up around 19% over the past year but off 40% from its all-time high just above $20,000, according to Coinbase quotes.

“If [investors] think there’s the same rigor around that price discovery as there is on the Nasdaq or New York Stock Exchange … they are sorely mistaken,” said Clayton, the opening speaker at the Delivering Alpha conference. “We have to get to a place where we can be confident that trading is better regulated.”

Digital assets are all the rage today.

While just a thought a year ago now they are front and center – getting attention in more common spaces than in the more savvy echelons of Wall Street. So much so, that even the recent Security Traders Association’s 86th annual Market Structure Conference in Washington D.C. had a panel discussion on them.

Amid some changes in senior leadership and a new corporate office space, tZERO’s Chief Executive Officer Saum Noursalehi spoke with Traders Magazine about the state of the digital asset market, liquidity and trading, and the firm’s plans for a new marketplace.

TRADERS MAGAZINE: What are your thoughts on the state of digital asset creation?
Saum Noursalehi: Digital asset creation is in an exciting place. It has been progressing steadily as infrastructure (e.g. blockchains, smart contracts) and the tokenization and trading platforms built on top of this infrastructure continues to innovate and enter the mainstream, in a thoughtful and compliant manner.

tZERO is in communications with a robust pipeline of prospective issuers of security tokens spanning a wide breadth of assets, including private/public companies, real-estate, funds and film. Prospective issuers are beginning to recognize the benefits that blockchain technology can offer.

TM: Is the pace slow or just right?

Noursalehi: The pace is slower than I would like, but this is to be expected given the level of regulation in financial services. Recreating capital markets by using blockchain and smart contract technology requires a solid understanding of what is achievable today, market education and close collaboration with the regulators to ensure investor protection.

Today, security tokens and security token trading ecosystems are analogous to the first cellular network towers and Motorola “brick” mobile phones. Those early products were not at their full potential; however, they showed the promise and capacity for cell phones to become far more superior to what was traditionally available. While tZERO nominally builds mobile phones (tokens), our focus and key to success lies in building a next-generation global network (just as it was in the early years of cellular technology, what matters is who owns the towers). This is where tZERO not only has a substantial lead, but also has patents protecting how the network is built.

TM: What is the best way to promote liquidity in the sector?

Noursalehi: The best way to promote liquidity is to create a robust marketplace for the secondary trading of digital securities, which is what tZERO’s wholly-owned subsidiary, PRO Securities, strives to do through its ATS. We are working to expand our ecosystem to onboard more quality security tokens for trading, subscribe more broker-dealers to facilitate trading and partner with more clearing firms to settle the trades. At tZERO, we are confident that we can expand the model used for our security token, TZROP, into a vibrant marketplace for attractive securities that not only complies with existing laws and practices, but also benefits from blockchain technology’s advantages. Once issuers have a clear path to liquidity, it will ignite the issuance of digital securities.

TM: What are some of the issues that need to be addressed to better facilitate digital asset trading?

Noursalehi: We are live with trading on the PRO Securities ATS, but we need more quality assets trading on our ATS, as well as more broker-dealers subscribing to it. It is a bit of a “chicken or the egg” issue – you need quality securities to attract major players and investors to the ecosystem, but you also need investors to attract those assets to the ecosystem. We are approaching this supply and demand challenge from both ends by working with issuers and other regulated institutions to encourage them to enter the ecosystem.

TM: Can you discuss the regulatory future of digital assets?

Noursalehi: tZERO is a proponent for progress and change in capital markets and we are pushing to advance regulatory laws, however, this change will be incremental and requires complying with existing laws and utilizing traditional regulations, with the added benefit of blockchain and smart contract technology to enhance the investor and issuer experience in a way that does not compromise that.

There are also promising signs for change like the recent legislation in Wyoming, which enables innovation and creativity in this space. States have often been the laboratories for new legal landscapes in this country. Wyoming will hopefully serve as an example to the nation of how distributed ledger technology improves market efficiency without sacrificing the safeguards for market participants.

TM: Why do you believe that digital assets are the future and what are the specific advantages they offer compared to traditional equity investing?

Noursalehi: I believe that digital assets are the future as they have a number of advantages over traditional equity investing, including democratized access to assets that traditionally had limited access, instant settlement and increased liquidity for traditionally illiquid assets (e.g. private securities, real-estate and funds).

TM: What are some of the major advancements you see over the next six months to a year that will impact digital asset trading?

Noursalehi: In the next year, we will see higher-quality assets being tokenized and trading, as well as more liquidity on the ATS. Furthermore, in partnership with BOX Digital Markets, we also expect to launch the first regulated national security token exchange through our joint venture, the Boston Security Token Exchange (BSTX). With BOX’s experience in building and operating a sophisticated securities exchange and tZERO’s industry leading blockchain technology, we have brought together our organizations’ combined expertise to fundamentally improve the marketplace for digital securities. We expect this to launch in 2020.

As a sign of the evolving U.S. equity trading landscape, two startups and one options exchange operator plan to launch as many as three new exchange platforms in 2020, and a fourth could be waiting in the wings.

Members Exchange (MEMX), Long Term Stock Exchange (LTSE), and Miami International Holdings, operator of the MIAX Exchange Group, plan to compete with incumbent stock exchange operators, according to speakers at the SIFMA Equity Market Structure Conference held Sept. 19 in New York City.

On Oct. 2nd, Reuters reported that Intelligent Cross, a dark pool based on artificial intelligence, plans either to become an exchange or partner with an exchange to distribute its quotes to the public to better compete with the likes of the New York Stock Exchange and Nasdaq. Now the startup wants to distribute bids and offers of its second order book, Adverse Selection Protection Engine or Aspen. “Our goal is to get our quote on the tape,” said Roman Ginis, CEO of Imperative Execution, who also spoke at SIFMA.

All of this is happening at a time when regulators and industry participants are calling for a review of Reg NMS and the Order Protection Rule, which were passed nearly 15 years ago when exchanges were not automated.

Emphasizing the need for competition and innovation in US equity market structure, new entrants have downplayed the increased connectivity costs and additional fragmentation of orders across trading venues.

Even a regulator suggested the stock market is not as competitive as it could be.

“Despite the growth in numbers of exchanges, 12 of the 13 active markets account for 60% of the ADV [average daily volume],” said SEC Commissioner Elad Roisman, in a keynote speech at SIFMA, who pointed to the consolidation of stock exchanges that has occurred through acquisitions.

“Competition is very good for the market,” said Jonathan Kellner, CEO of Members Exchange or MEMX, the startup owned by nine high-profile firms: Bank of America Merrill Lynch, Charles Schwab, Citadel Securities, E*TRADE, Fidelity Investments, Morgan Stanley, TD Ameritrade, UBS, and Virtu Financial.

But with 13 stock exchanges currently operating, that number could soon rise to 16 exchanges, causing some to question the value proposition to buy-side investors who already navigate a complex landscape. “Why do we need another?” asked Sapna Patel, Executive director, Head of Americas Market Structure and Liquidity Strategy at Morgan Stanley, who was asking the question on behalf of the buy side.

Citing the need for competition and innovation, Kellner said, that MEMX would push other exchanges to innovate and it would put pressure on fees. Also, he said it will give brokers a voice at the market structure debate as SROs [self- regulatory organizations] on issues like market data, which was the main catalyst in the formation of MEMX, he said. By forming their own exchange, broker dealers that own MEMX will gain a seat on the SIP Operating Committee which governs the securities information processor – or SIP – the consolidated market data feed.

As far as the cost of connecting to additional exchanges, based on conversations with broker dealers, Kellner maintained that the increased cost to connect is minimal. “The benefits outweigh the increased costs,” he asserted.

The drive to lower costs with new technology is also central to Miami International Holding’s (MIH) value proposition. “We’re going to start out 40% cheaper than the lowest cost operator today,” said Thomas Gallagher, chairman and CEO of MIH, which established MIAX Exchange Group.

MIAX’s three options exchanges — MIAX Options, MIAX Pearl and MIAX Emerald — are on track to trade 500 million contracts this year and have garnered between 10 and 11 percent market share in options trading.

“We will take that technology infrastructure and apply it to equities,” said Gallagher, who said he raised about $300 million to build the infrastructure from investors that are families in the Middle East, Latin America, and Europe who wanted the transparency of an equities exchange. As a differentiator, the new equities exchange will go after the Hispanic entrepreneur and plans to have region specific securities offerings.

Simplifying Order Types

While the new venues collectively are going to inject more platforms into the market structure, each one claims its goal is to simplify trading.

“Our game plan is to keep it simple, keep it cheap. Create incentives for the industry to participate,” said Gallagher, who said it was aligning owners with users, following a model like MEMX.

MIH partnered with Hudson Trading and CTC Trading Group to launch a cash equities exchange to supplement is options business under the MIAX Pearl license, reported The Trade in May. MIAX also received investments from existing exchange members IMC, Simplex Trading, Susquehanna Securities, and Two Sigma.

As it did with options, MIAX’s strategy has been to offer liquidity providers an equity stake if they maintain certain volume threshold’s over time. “We will offer six or seven liquidity partners the right to own about 3.5 % of the company over the next 36 months from the launch date if we deliver on what our promise is,” said Gallagher. He expects the equities exchange to launch in the Q2 or Q3 of next year.

Differentiate with Technology

For its part, MEMX also wants to simplify the order types, noting that its member owners are familiar with all the order types that exist.

“The differentiator here is we have a greenfield opportunity to build an exchange from scratch,” said Kellner. “Technology has really improved over the last few years. We’re not looking to innovate via the market structure. We’re looking to innovate via technology,” said Kellner.

Likewise, Long Term Stock Exchange CEO Zoran Perkov said the LTSE will offer a “simple market model” with simple order types. “Our simple market model is a trading platform; it carries a subset of what you find in the broader market where you only have the ability to display an order,” said Perkov, a serial builder of SROs who previously worked at Nasdaq and IEX.

While other new entrants are aligned with broker dealers or market makers, LTSE is the first U.S. national securities exchange primarily designed to support corporate issuers and investors “who measure success in years and decades, not financial quarters,” stated LTSE in a Sept. 18 announcement.

In that release, LTSE said it intends to file a rule proposal with the SEC to change the rules, so that all buying and selling of shares will occur exclusively at prices displayed to all participants.

On LTSE, there won’t be any hidden or reserve liquidity on that market. “There will be simple order types on that market. We feel that is consistent with the idea of what an exchange is — one allowing companies to raise capital and allowing investors to express their interest,” he said.

Incumbents Weigh New Venues

Meanwhile, incumbent exchanges such as Nasdaq, which own additional exchange licenses, could have the option to light up another venue at any time. “We have six medallions and three are idle, said Tal Cohen, Executive Vice President and Head of North American Market Services at Nasdaq on the SIFMA panel.

“Nasdaq looks to solve problems in the market,” said Cohen, stressing that the exchange operator grapples with the decision of how to deploy its exchange licenses.

“We are trying to be responsible. We’re trying to understand the segments of the market that require competition,” said Cohen.

For example, “if there are illiquid names that trade 5,000, 10,000, or 15,000 shares a day, Nasdaq would weigh, do we need a 15th or 16th exchange?” explained Cohen. He said that Nasdaq has been thoughtful in not lighting up another venue, pointing to the decision to offer the Midpoint Extended Life Order or M-ELO, as a non-displayed order type. “We made a conscious decision of innovating on an existing platform vs. launching a fourth medallion,” said Cohen.

With the focus of exchanges on price and speed, some argue that it has been difficult for public exchanges to innovate under Reg NMS.

“The current regulatory environment certainly dictates how innovative you can be in this space. And price-time in a Reg NMS world, and especially the Order Protection Rule, constrains you to a certain degree,” said Patel of Morgan Stanley.

Some have blamed the Order Protection Rule (OPR) for the proliferation of small exchanges since the rule requires brokers to route investor orders to protected quotes that are immediately accessible.

Calls to Reassess Order Protection Rule

In his keynote speech at SIFMA’s conference, SEC Commissioner Roisman suggested the Commission ought to look more closely at providing more guidance on best execution and to reassess the Order Protection Rule known as OPR which has allowed exchanges to get “protected quote status” under Regulation NMS.

OPR, or Rule 611, also known as the trade-through rule, “establishes intermarket protection against trade-throughs for all NMS stocks,” according to Reg NMS. It “requires trading centers­ to enforce written policies and procedures to prevent the execution of trades at prices inferior to protected quotations displayed by other trading centers, subject to an applicable exception. To be protected, a quotation must be immediately and automatically accessible.”

Trading centers are broadly defined to include all types of venues including registered exchanges, ATSs, off-exchange market makers, and any other broker-dealers that execute trades internally as principal or agent.

However, OPR has been criticized for causing lit venues to compete based on speed and maker-taker fees, rather than stability and liquidity.

Roisman suggested that brokers are ignoring other factors pertaining to best execution, such as size, trading characteristics, transaction costs and ease of fill. “My concern is that emphasis on price and time and the avoidance of trade-throughs has become a substitute for a more robust best execution analysis,” said Roisman adding that brokers may be focusing on these two factors to avoid criticism from regulators and customers.

Roisman also noted that OPR has “forced brokers to connect to, purchase market data from, and take into account prices on all exchanges.” To lower the cost of connecting to many smaller exchanges, some suggest there should be a volume threshold to qualify for a de minimis exception from OPR applying to small exchanges.

“If we’re going to try to address concern about fragmentation and the cost of interacting and the technology to interact with ‘N‘ number of markets, then it’s natural that OPR is going to become part of that discussion,” said Michael Blaugrund, Head of Equities at NYSE, which operates five venues.

“Should OPR apply only to exchanges that reach a specific minimum ADV over a set period -of time?” asked the SEC Commissioner.

Proposed Exceptions to OPR

Various proposals are pending before the SEC to create a de minimis exception to OPR for old and new small exchanges. Nasdaq has proposed a threshold of at least 1.5 % of the volume, while NYSE proposed 1% before venues would qualify for protection. Other ideas are to utilize OPR only for listed markets or to create a display threshold, said Blaugrund.

However, any volume threshold for OPR could raise the barriers to entry for new entrants that meet the requirements of an exchange.

MIH’s Gallagher said it would be unjust for the SEC to change the rule now since that would hurt new exchanges from building up their volumes. It takes several years to offer the innovations and get SEC approval, he noted.

“If until you get to a certain market share or displayed volume threshold you can’t have any assistance, I don’t think that’s fair,” said Gallagher. If there is a new rule, then the SEC should give new entrants a period-of-time to get traction, he said.

Amidst all the talk of reviewing or eliminating the OPR, panelists suggested there should be more discussion with the industry before reaching any conclusions, while the SEC Commissioner and new entrants warned of unintended consequences. Wearing his engineering hat, Perkov suggested it could take years to remove the OPR code from everyone’s systems. In the meantime, the exchange landscape will continue to evolve.

The European Union’s Securities Financing Transactions Regulation, which introduces challenging reporting requirements, goes live for broker-dealers in six months time but the market is still waiting for the final specifications from regulators.

SFTR requires all securities financing transactions including repos, securities lending and margin lending trades, to be reported to an authorised trade repository the day after a trade using a unique transaction identifier. The data, consisting of approximately 150 fields, should allow supervisors to monitor market developments such as the build-up of leverage in the financial system. In addition, there are new disclosure obligations and collateral reuse obligations.

Val Wotton, managing director, product development and strategy, derivatives and collateral management at DTCC, the US market infrastructure, said in a statement on 12 October  that the day marked six months until the introduction of SFTR for broker-dealers and a year until the implementation date for asset managers

“While the broker-dealers have made good progress in their readiness for SFTR implementation, the smaller and medium-sized asset managers have much further to go in their preparations in order to be compliant in time,” added Wotton.

Buy-side firms that lack the resources to build and manage technology for their own transaction reporting can delegate to their broker but issues have emerged around areas such as collateral reuse.

“This is why buy-side firms need to prioritise SFTR readiness now, to ensure that they have ample time to implement the optimal model for their needs, which may include assisted reporting, whereby service providers help buy-side firms to fulfil their obligations while easing the burden for dealers,” said Wotton.

Reporting challenges

The new reporting requirements are challenging for a market which has traditionally been very manual.

However, James Stacey, regulatory business analyst, at London Stock Exchange’s clearing house LCH, said in a media briefing that the industry and regulators have learnt from the implementation of Emir.

The Emir regulation went live in the EU in 2014 and introduced new reporting requirements for centrally cleared derivatives to authorised trade repositories. There were issues with poor data quality and lack of reconciliations between the repositories.

Stacey said: “For SFTR there are strict matching criteria applicable to reporting, such as those applicable to collateral valuations, and the approach of phasing in reconcilable fields means matching does not all have to happen on day one, giving firms time to resolve issues with their reporting even after the official go-live dates.”

In addition, for cleared trades, central counterparty clearing houses will be holders of the golden source of trade data so disputes should be significantly reduced.

“CCPs are not required to go live with SFTR reporting until Phase II in July next year but LCH plans to go live in the first phase in April to improve matching rates for our members from day one,” he said.

LCH initially launched a sponsored clearing model in 2017 to give buy-side firms access to cleared repo and Stacey continued that interest has been growing. This is live for sterling repo in LCH Ltd in London and will soon be launched for euro repo in LCH SA in France.

“This model will also provide buy-side firms with access to CCP reporting which should ease the burden of information gathering,” added Stacey.

Axel Pierron, co-founder and managing director at capital markets consultancy Opimas, said in a report that a greater reliance on services provided by CCPs could have a profound impact on securities lending by reducing the need for intermediation by prime brokers. He wrote that two CCPs offers such services, Deutsche Börse’s Eurex Clearing in Europe and the OCC in the US.

“While these services have been available for quite some time, the volume has not yet materialized, as opposed to what has happened with repo transactions where we’ve witnessed a clear uptake,” he said.

Pierron continued that Eurex announced in June this year that BNY Mellon was the first agent lender to centrally clear securities transactions on behalf of a buy-side client through its lending platform. “This demonstrates that there is a long way to go before such practices become the market standard, if ever,” he said.

Technology

The European Commission adopted SFTR in December last year but market participants are still waiting for the Level 3 text with the final regulatory specifications. LCH has sent reporting specifications to members and connectivity testing is due to begin in January, subject to the publication of Level 3 text.

In order to make trade reporting easier, UnaVista has launched assisted reporting. LSEG’s regulatory reporting unit will validate, cleanse and augment datasets, although ultimate responsibility still remains with the client.

SFTR requires a Unique Trade Identifier (UTI) to be used when #RegulatoryReporting but which party is responsible for its creation? This and 5 critical factors for #SFTR are discussed here https://t.co/QcnoTHQK46 in this article by Sarah Peaston @RegulatoryGove1 pic.twitter.com/WFpbTKmBXb

— Regulatory Reporting (formerly UnaVista) (@LSEG_Reporting) October 9, 2019

Catherine Talks, product manager at Unavista, said in a media briefing: “With such an extensive reporting obligation firms are taking this opportunity to review legacy systems and change operational models to adhere to the T+1 reporting requirement. There is innovation happening in the market and we are seeing a rise of partnerships to assist firms in their reporting, we have a number of models that work alongside software providers to help firms with their reporting obligations.”

Although reporting may be challenging to implement, Talks continued that the market could also eventually benefit from opportunities to generate analytics from the data, such as trends within a peer group or certain risks associated with particular activities.

Opimas said SFTR represents a significant opportunity for securities lending software solution providers to deliver reporting services to market participants. In the study, Sizing Up the Securities Lending Market and Its Solution Providers, the consultancy estimated that post-trade solutions market in securities lending will grow from $350m this year to nearly $400m in 2021.

Shift to electronic trading

Tom Harry, product manager MTS, said at the media briefing that cleared inter-dealer repo trades are executed electronically. However, many exotic trades are still executed manually, so LSEG’s fixed income trading venue is trying to facilitate a move to electronic trading.

“Dealer to client trading is typically executed by voice, so SFTR is a significant hurdle for many participants,” said Harry. “To help facilitate the transition, MTS is offering an SFTR blotter for both bilateral and cleared trades which includes the required reporting fields.”

Harry said MTS is also seeing changes in customer behaviour, particularly with regard to processed trades. “These are negotiated bilaterally but then executed on a venue to allow straight-through-processing and reporting,” he said.

In order to increase electronic trading, Hudson Fintech this month launched a front office technology platform for sell-side and buy-side institutions trading in the repo markets.

The firm said in a statement that it was established to help market participants meet the need for increased regulatory reporting and transparency, improved risk management processes, and balance sheet constraints.

“Regulators around the world demand increased data control and reporting, leading to many financial institutions reviewing their outdated legacy systems, typically using multiple technology bolt-ons, which limit the flow and efficiency of trading operations,” said the statement.

Hudson said its core technology is based on an advanced system architecture, known as Entity-Component-System. ECS architecture has fewer interdependencies so it is more flexible, and faster and cheaper to develop. Code is extensively re-used with continuous automated testing so less time is spent on manual regression testing. The firm said it aims to reduce the time taken to upgrade systems and cut typical licence fees by up to 50%.