DEA users sub-delegating DEA to Tier 2 clients trading on own account or executing client orders should be authorised as investment firms - true or false?
Before we refer to the above question let's explain that DEA sub-delegation, in principle, allows brokers and intermediaries who do not have the scale to be a direct member of all EU trading venues to provide access to liquidity pools to their clients without bearing the cost and complexity linked to membership to multiple venues.
DEA sub-delegation allows non-EU affiliates of the same group to access EU markets (possibility particularly interesting in the context of Brexit).
Tier 2 DEA clients may include EU regulated entities, EU entities that are not regulated under MIFID II but benefit from a MiFID II exemption (e.g. ancillary activity exemption) and third-country entities that have at least some form of local regulatory authorisation.
DEA sub-delegation is, however, a mysterious thing in financial legislation and practice, resembling yeti or so, as some consider it frequent and important, including access to listed derivatives markets, while others perceive the phenomenon as not very common; possibly, there may be even those who believe that there is no such thing at all.
In any case, market perception of DEA sub-delegation differs and recent ESMA Report (MiFID II/MiFIR Review Report of 28 September 2021 on Algorithmic Trading, ESMA70-156-4572) attests to that.
The definition of DEA (Direct Electronic Access) as “an arrangement where a member or participant or client of a trading venue permits a person to use its trading code so the person can electronically transmit orders relating to a financial instrument directly to the trading venue [...]” infers a direct contractual arrangement between the DEA provider and the DEA client.
A person who directly interacts with the member to obtain the use of its trading code, and who is explicitly authorised by the member to use it, has a DEA to a trading venue.
Where the DEA client sub-delegates the DEA access, and in contrast to the circumstances described above, the person benefitting from the DEA sub-delegation (Tier 2 DEA clients) would, in most cases, not technically be in possession of the trading code of the DEA provider.
This is because the trading code is not passed down in such a case to the ultimate users of DEA, but only appended to the order message by the DEA provider before being submitted to the trading venue.
Therefore, ESMA does not consider such Tier 2 DEA clients as having DEA for the purpose MiFID own account exemption of Article 2(1)(d) of MiFID II.
To address the uncertainty that has arisen in relation to DEA sub-delegation and Tier 2 clients ESMA proposed to introduce a definition of DEA sub-delegation in Article 4 of MiFID II, and not let this concept only appear incidentally (like a yeti) in RTS 6 (which requires the identification of the different order flows from the DEA sub-delegation beneficiaries).
This would allow to clarify that Tier 2 DEA clients should be considered DEA users for the purposes of MiFID II obligations relating to DEA.
However, these legislative proposals, as well as existing framework indeed give rise to different interpretations.
Making long story short ESMA in the recent regulatory paper invited the European Commission to clarify whether DEA users sub-delegating DEA to Tier 2 clients trading on own account or executing client orders should be authorised as investment firms.
In addition the ESMA proposes that DEA users only dealing on own account and not sub-delegating access should no longer be required to be authorised as investment firms.
With respect to the latter initiative the response was quick and positive (European Commission Proposal 25 November 2021 for a Directive of the European Parliament and of the Council amending Directive 2014/65/EU on markets in financial instruments, COM(2021) 726 final).
Hence, only the dilemma highlighted upfront still awaits clarity.
It is also useful to note enhanced regulatory oversight, as, in parallel, the regulator proposes to amend the third paragraph of Article 17(5) of MiFID II to include the list of DEA users to which DEA is provided (including Tier 2 clients benefitting from sub-delegation) in the notifications by DEA providers, together with an annual update of the list.