Request-for-quote (RFQ) system
A 'request-for-quote’ (RFQ) system is the dominant trading protocol used by market participants whether trading on venues, MTFs, OTFs or with SIs (SMSG Response of 23 March 2020 to ESMA’s Consultation Paper concerning MiFIR report on Systematic Internalisers, ESMA22-106-235, p. 2).
12 July 2023
ESMA Report on the Call for Evidence on pre-hedging, ESMA70-449-748. ESMA concludes that pre-hedging is a voluntary market practice which might give rise to conflicts of interest or abusive behaviours. Whereas ESMA does not find arguments to ban this practice at this stage, it also flags that these risks should be considered when issuing any future guidance.
29 July 2022
RFQ is a trading system where the following conditions are met:
(a) a quote or quotes by a member or participant are provided in response to a request for a quote submitted by one or more other members or participants;
(b) the quote is executable exclusively by the requesting member or participant;
(c) the requesting member or market participant may conclude a transaction by accepting the quote or quotes provided to it on request.
The above definition is stipulated in Article 1(2) of the Commission Delegated Regulation (EU) 2017/583 of 14 July 2016 supplementing Regulation (EU) No 600/2014 of the European Parliament and of the Council on markets in financial instruments with regard to regulatory technical standards on transparency requirements for trading venues and investment firms in respect of bonds, structured finance products, emission allowances and derivatives (RTS 2). Moreover, the ’request-for-quote trading system’ is listed in the Annex I to the RTS 2 (the said Annex enumerates the types of systems and the related information to be made public for the purposes of pre-trade transparency requirements in articles 3(1) and 8(1) MiFIR), where the ‘description of the system’ is as follows:
“A trading system where a quote or quotes are provided in response to a request for a quote submitted by one or more other members or participants. The quote is executable exclusively by the requesting member or market participant. The requesting member or participant may conclude a transaction by accepting the quote or quotes provided to it on request.”.
The same description of the RFQ trading system is contained in the analogous Annex I of Commission Delegated Regulation (EU) 2017/587 of 14 July 2016 supplementing Regulation (EU) No 600/2014 of the European Parliament and of the Council on markets in financial instruments with regard to regulatory technical standards on transparency requirements for trading venues and investment firms in respect of shares, depositary receipts, exchange-traded funds, certificates and other similar financial instruments and on transaction execution obligations in respect of certain shares on a trading venue or by a systematic internaliser (RTS 1).
RFQ system in the light of the above Annexes can be considered as the one of the two types of ‘quote-driven systems’ (the second being the ‘quote-driven trading system’ and described in the Annex as ‘a system where transactions are concluded on the basis of firm quotes that are continuously made available to participants, which requires the market makers to maintain quotes in a size that balances the needs of members and participants to deal in a commercial size and the risk to which the market maker exposes itself’).
The description of this second type - quote-driven trading system - uses the plural and assumes that more than one market maker is active in the system (Christoph Kumpan, Hendrik Müller-Lankow, The multilateral single-dealer system - an oxymoron under MiFID II?, 13 September 2017, p. 11).
As regards the RFQ trading system as the type of a ‘quote-driven system’ the said publication highlights that in the system description:
- ‘a quote or quotes are provided’ in response to a quote request, and
- the requesting member can conclude a transaction by accepting ‘the quote or quotes’, which makes possible two potential interpretations.
The use of the singular may mean that:
- only a single market maker is acting in the system, or
- one market maker out of several market makers has responded to the quote request.
The authors invoke the wording of the fifth sentence of recital 7 of MiFIR:
„Regulated markets and MTFs are not obliged to operate a ‘technical’ system for matching orders and should be able to operate other trading protocols including systems whereby users are able to trade against quotes they request from multiple providers” and conclude that the latter interpretation is likely intended. Under that interpretation, regulated markets and multilateral trading facilities may implement a multitude of trading protocols including systems whereby users are able to trade against quotes they request from multiple providers.
According to the ESMA’s view expressed in the Consultation Paper of 18 January 2022 on the Opinion on Trading Venue perimeter (ESMA70-156-4978). systems that allow multiple third-party interests to interact but where, occasionally, bilateral interaction occurs too, should also be captured within the trading venue perimeter. As the ESMA said, "this applies, for example, to the case of RFQ systems that can be used by members or participants at their discretion as an RFQ-to-one tool, i.e. a tool that allows (or requires) sending a request to only one counterparty". According to the ESMA's view:
“RFQ systems as described in RTS 1 and 2, i.e. systems where quotes are provided in response to a request submitted by one firm, are generally regarded as multilateral systems and as requiring authorisation as a trading venue under MiFID II. Such conclusion stems from the fact that those systems enable the interaction of trading interests from multiple counterparties and are hence in the scope of the definition of multilateral system in Article 4(19) of MiFID II. The latter conclusion encompasses also systems that provide for RFQ to one functionalities, as further detailed below. In fact RFQ to one systems allow clients to send individual request for quotes to multiple dealers (either at the same time or separately), even if only using an RFQ to one functionality, hence enabling multilateral interaction of trading interests”.
Limiting the number of participants a firm can request quotes from
In the Questions and Answers on MiFID II and MiFIR market structures topics of 7 July 2017 (ESMA70-872942901-38) ESMA underlined that in a request for quote (RFQ) protocol, a trading venue should not impose limits on the number of participants that a firm can request a quote from. Whilst a firm requesting a quote may, in compliance with Article 28 of MiFID II, want to limit the number of participants it requests quotes from in order to minimise the risk of unduly exposing its trading interest, which could result in it obtaining a worse price, this should not be mandated by the trading venue. For instance, where a smaller firm is requesting a quote to execute a low volume trade, it might be less concerned about the risks of exposing its trading interest, and so happier to request quotes from a larger number of market makers or liquidity providers.
Limiting the number of participants a firm can request quotes from risks restricting the ability of market participants to access liquidity pools, and only sending requests to traditionally larger dealers who they assume might have larger inventories. This simultaneously restricts the ability of the requestor to access the best pool of liquidity and reduces the likelihood of a smaller dealer receiving requests, despite it having a strong trading interest.
Pre-trade transparency of RFQ systems
Questions and Answers on MiFID II and MiFIR transparency topics, ESMA70-872942901-35
Question 7 [Last update: 29/05/2018]
When should the operator of an RFQ system provide pre-trade transparency?
Trading venues are responsible for designing their RFQ systems in compliance with the pre-trade transparency requirements defined in MiFIR and specified in Annex I of RTS 1 and RTS 2. The arrangements used may differ depending on the approach chosen by individual trading venues. Such approaches might include arrangements where trading interests become executable after a pre-defined period of time but would, in any circumstances, require the indications of interest to be disclosed no later than when they become actionable and in any case before the conclusion of a transaction. However, the conclusion of a transaction is not a condition for the publication of pre-trade transparency. Therefore, pre-trade transparency should also apply where a quote provided on request, including actionable indications of interest, is not acted upon.
The disclosure of the pre-trade quotes or actionable indications of interest only at the time of execution would not be consistent with the obligations set in Annex I of RTS 1 and 2.
In the Answer to Question 7 (updated on 3 October 2017, Questions and Answers on MiFID II and MiFIR transparency topics, ESMA70-872942901-35) ESMA raised the issue when the operator of an RFQ system should provide pre-trade transparency. According to the ESMA, trading venues are responsible for designing their RFQ systems in compliance with the pre-trade transparency requirements defined in MiFIR and specified in Annex I of the RTS 1 and Annex I of RTS 2. The arrangements used may differ depending on the approach chosen by individual trading venues. Such approaches might include arrangements where trading interests become executable after a pre-defined period of time but would, in any circumstances, require the indications of interest to be disclosed no later than when they become actionable and in any case before the conclusion of a transaction.
ESMA underlined that the disclosure of the pre-trade quotes or actionable indications of interest only at the time of execution would not be consistent with the obligations set in Annex I of RTS 1 and 2.
The aforementioned Annex I to the RTS 1 and Annex I to the RTS 2 require the following to be made public by the RFQ trading systems:
“The quotes and the attaching volumes from any member or participant which, if accepted, would lead to a transaction under the system's rules. All submitted quotes in response to a request for quote may be published at the same time but not later than when they become executable.”
Recital 7 of the RTS 1 reads:
“A trading venue operating a request for quote (RFQ) system should at least make public the firm bids and offer prices or actionable indications of interest and the depth attached to those prices no later than at the time when the requester is able to execute a transaction under the system's rules. This is to ensure that members or participants who are providing their quotes to the requester first are not put at a disadvantage.”
In the answer to the Question 5 (Questions and Answers on MiFID II and MiFIR market structures topics, Multilateral and bilateral systems, updated on 15 November 2017) ESMA underlined that “there is no new client relationship between two counterparties to a trade that takes place on a trading venue, including when the trading venue operates on a request for quote basis”.
Questions and Answers on MiFID II and MiFIR market structures topics
Question [Last update: 15/11/2017]
Does a client relationship exist between two counterparties that trade on a trading venue?
No, there is no new client relationship between two counterparties to a trade that takes place on a trading venue, including when the trading venue operates on a request for quote basis.
Question [Last update: 05/12/2019]
To which types of trading systems does Commission Delegated Regulation (EU) 2017/584 RTS 7 apply? In particular, are trading venues without auto-matching trading systems or that explicitly prohibit algorithmic trading subject to the provisions of RTS 7?
Article 1 of RTS 7 limits the scope of application of RTS 7 to trading venues which “allow or enable algorithmic trading”. Article 1(2) of RTS 7 defines those venues as trading venues “where order submission and order matching is facilitated by electronic means”. The rationale is explained in Recital 3 which clarifies that “risks arising from algorithmic trading can be present in any type of trading system that is supported by electronic means”.
ESMA further notes that Recital 5 of RTS 7 explicitly refers to request-for-quote systems, where transactions are usually not automatically executed based on pre-set parameters and logic (i.e. no auto-matching protocols), as being within the scope of the RTS. ESMA therefore consider that the absence of an auto-matching protocol should not exclude the trading venue operating such system from the scope of RTS 7.
Similarly, an explicit prohibition of algorithmic trading does not appear sufficient for the trading venue to be excluded from the scope of the RTS considering the definition of trading venues allowing or enabling algorithmic trading provided under Article 1(2).
Nevertheless, regarding the specific application of the provisions contained in RTS 7, Recital 5 clarifies that (i) “some organisational requirements may not be appropriate for certain trading models although their trading systems could be supported to a certain extent by electronic means” and that (ii) “the specific requirements to be set in relation to request-for-quote systems or hybrid systems should be considered according to the nature, scale and complexity of the algorithmic trading activity undertaken”. ESMA would for instance consider it unreasonable to require a trading venue that explicitly prohibits algorithmic trading to offer to its clients a simulation facility for testing algorithms in conditions that are as realistic as possible (Article 10(2) of RTS 7).
Lastly, Recital 3 clarifies that voice trading systems are excluded from the scope of RTS 7. It is however important to stress that trading venues operating such systems remain subject to the organisational requirements prescribed under Article 48(1) of MiFID II.
Questions and Answers on MiFID II and MiFIR investor protection topics, ESMA35-43-349
Question 19 [Last update: 3 October 2018]
In some instances, investment firms use the RFQ system of a trading venue that allow firms to identify and select the different counterparties they wish to obtain quotes from, before concluding the trade with the selected counterparty on that trading venue’s RFQ system.
Where an investment firm agrees a trade via such systems, should it identify the counterparty with whom the transaction was agreed with or the trading venue used to ultimately conclude the transaction for its RTS 28 reporting?
Sometimes, investment firms select and approach one or more potential counterparties, obtaining quotes from them using the non-anonymous request-for-quote (RFQ) systems of a trading venue and agree the trade with their selected counterparty on that trading venue’s RFQ system.
This is common across asset classes, but is especially prevalent, for example, in bond markets, where some trading venues allow investment firms to identify different liquidity providers that the firm may wish to deal with in the transaction, and obtain quotes from them before executing the transaction with their selected counterparty on the trading venue.
ESMA considers that a transaction is deemed to be executed on a trading venue, where it is carried out under the rules of the trading venue. Correspondingly, a firm executing orders on behalf of clients or decisions to deal under the rules of a trading venue would need to identify the trading venue in question in its RTS 28 reports.
ESMA also recognises that the objective of RTS 28 is to make the sources of liquidity used as well as firms’ order routing practices more transparent. ESMA is of the opinion that where investment firms use the RFQ systems of a trading venue that allow the investment firm to identify the counterparty they are dealing with, this objective is better achieved if an investment firm provides information about the counterparty it has approached for a quote and selected to execute the transaction through such systems, before concluding the trade on that trading venue’s RFQ system.
For the RTS 28 reports to accurately reflect the investment firm’s venue selection process and order execution policy and behaviour, and to provide an accurate picture of the investment firm’s order routing practices and considerations, ESMA considers that as part of the summary of the quality of execution obtained on the different venues used (Article 3(3), Recital 11), the investment firm should also disclose the identity of the (five) counterparties it most commonly executes against where they have agreed the trade via an RFQ system of a trading venue that allows the firm to identify the counterparty they are dealing with. The firm should also disclose the proportion of volume traded with each of these counterparties as a percentage of the total in that class of financial instruments. This disclosure should also include information about the existence of any close links, conflicts of interest, common ownerships and specific arrangements with such counterparties in its summary of execution quality,14 and for this information to be consistent with the information to be provided under Article 3(3) of RTS 28.
Commission Delegated Regulation (EU) 2017/584 of 14 July 2016 supplementing Directive 2014/65/EU of the European Parliament and of the Council with regard to regulatory technical standards specifying organisational requirements of trading venues
Requirements should be laid down with respect to the systems of trading venues allowing or enabling algorithmic trading. However, their specific application should take place in conjunction with a self-assessment to be conducted by each trading venue since not all trading models present the same risks. Therefore, some organisational requirements may not be appropriate for certain trading models although their trading systems could be supported to a certain extent by electronic means. In particular, the specific requirements to be set in relation to request-for-quote systems or hybrid systems should be considered according to the nature, scale and complexity of the algorithmic trading activity undertaken. Equally, more stringent requirements should be established by the trading venues where appropriate.
Pre-hedging in the RFQ systems - market abuse concerns
ESMA in the Consultation Paper of 3 October 2019 (MAR review report, ESMA70-156-145, p. 35, 36) referred to conducts carried out in connection to requests for quotes and known as a “pre-hedging” or “anticipatory hedging”, i.e. situation where a broker acting as principal undertakes a transaction in anticipation of a client order in order to manage the risk associated with those client trades. More specifically, ESMA described the typical case of pre-hedging as the practice of the relevant broker, which, having received a request for quote from a client but not yet its firm order, hedges the position that it would have to take where it happened to win the request for quote (hence prior to the conclusion of the latter). ESMA noted increased number of suspicious transactions reports (STORs) from market participants on such behaviours.
ESMA’s concerns were as follows:
1. From a market abuse perspective, pre-hedging behaviours may create risks of potential insider dealing, if a broker were to use the information received from the client to trade on for its own account, including potentially trading against the client. In this respect, and provided that a case by case assessment is necessary, ESMA noted that the request for quotes often meets the definition of inside information.
2. Pre-hedging may present the risk of distorting competition and harming the client’s interests where there is competition between brokers (competitive requests for quote).
In such cases, pre-hedging may affect the market price of the relevant financial instrument and have consequences on the price that other competing firms show to the client before the conclusion of the request for quote. Such a situation is likely to impact negatively the client depending on various criteria, including if the pre-hedging has been carried out by firms other than the one that ultimately wins the request for quote.
From a conduct perspective, such behaviours may also create risks around managing conflicts of interest between the firm and their client, client order handling rules around fair execution of client orders, and best execution rules.
For example, a broker may receive a request for quote from a client, and pre-hedge that transaction. A broker who uses the information received in that request for quote for its own proprietary benefit, may not be acting in the interest of its client and, in addition, may be at risk of insider dealing.
For instance, there may be conduct and market abuse risks:
- where such a broker pre-hedges and then declines to provide a quote, or
- where such a broker could fill a client order from its existing inventory but trades aggressively in the market in a way that impacts on the price, or trades in a way which disadvantages another broker who executes the order for that client.
The risk for the client would be even greater where all the brokers involved in the request for quote pre-hedge, as the multiple price impacts would cumulate.
It would also be important from a conduct perspective for brokers to provide clients with sufficient transparency and disclosure about their use of pre-hedging arrangements, the application and functioning of those arrangements, and the potential impact and risk of pre-hedging arrangements on the execution of client orders.
Such transparency and disclosure would be important for clients to understand how their orders will be executed and the impact on their orders. ESMA also understands that the pre-hedging behaviours may be held out to benefit the client, by passing on the benefit of pre-hedging activities, to provide a better price to the client.
Pre-hedging is also held out to reduce the impact and disruption of large orders on the market. However, there is a potential risk around the extent to which the pre-hedging behaviour benefits the broker compared to the client.
In turn, the Securities and Markets Stakeholder Group (SMSG) in the document of 4 December 2019 (Advice to ESMA, Response to ESMA’s Consultation Paper on MAR review report, SMSG, ESMA22-106-204, p. 8) said:
“As regards Q22 and Q23 the SMSG considers that pre-hedging is a licit activity. It is in fact a diligent course of action for a counterparty asked to offer price on a Request for Quote basis, particularly where it refers to illiquid assets. Thus, no market abuse implications are seen here. Only when pre-hedging is used for liquid assets and when pre-hedging itself does not make sense for hedging purposes, potential market abuse concerns might arise”.