Brokers, internalization of orders and post-trade: competition amongst market infrastructures
The organization of the capital markets has been intrinsically related to technological development. Currently, there is a trendy but controversial perception that technology, such as Distributed Ledger Technology (DLT), can eliminate intermediaries and FMIs (i.e. exchanges, central security depositories and clearing houses) due to its peer-to-peer network and that a disintermediated model should reduce the overall cost of capital markets.
But scepticism in this debate is needed. Although it is consistent to argue that technology could propel market intermediaries to internalize trading and post-trade services rendered by FMIs, there are still regulatory concerns regarding the potential conflicts of interest evoked by such internalization. To illustrate this, investors may be jeopardized by the elimination of trusted third parties that guarantee asset validity, market integrity, risk management, amongst other crucial regulatory aspects. Who should be the gatekeeper in such model after all?
A pragmatic solution would involve specific intermediaries internalizing trade and post-trade activities, such as order flows, central depository services and clearing. This could be adopted especially in spot markets where the delivery versus payment (DVP) should happen without complex risk management infrastructures. But to accomplish this task, intermediaries must safeguard the same principles generally applicable to FMIs.
Internalization of orders entitle brokers to match buy and sell orders within their platforms without registering trade in organized markets. In Brazil, this is currently allowed in certain circumstances, such as trading of securities not listed on the stock exchange. However, the Brazilian Securities Commission (CVM) is on the verge of concluding Public Hearing SDM 09/2019, in which some market participants asked for broader permission to internalize securities listed on exchanges. Adjustments to the regulation of FMIs are indeed expected and can reveal future opportunities.
However, internalization raises pivotal concerns, such as transparency in price formation of traded assets and liquidity fragmentation of the market. Exchanges and over the counter (OTC) intermediaries are considered more transparent in price formation because of their trading systems and self-regulatory structure. As a result, they have become the main liquidity centers for investors.
To enhance competition without losing the benefits of organized markets, CVM should allow internalization with thresholds as a hindrance to liquidity fragmentation and should determine that brokers incorporate pre-trade and post-trade transparency in their trading platforms. Hence, brokers must guarantee that inner prices are automatically pegged to price variation of exchanges, thus maintaining exchanges as the main liquidity centers and price makers. In this context, interoperability with other trading venues, principally stock exchanges, is key to the success of internalization.
The Brazilian post-trade segment of securities comprises three main activities: central deposit, clearing and settlement. While there is no legal monopoly, B3 S.A. – the Brazilian Stock Exchange – is the only institution currently authorised by the Brazilian Central Bank (BCB) to clear and settle operations. Besides the high quality of services offered by B3 and the operational merits of this company, there is room for competition as observed in the U.S. and European markets.
Prime Brokers, meaning entities that offer special services (such as custody of assets or financial leverage) and client facilitation to institutional clients and other brokers, could perfectly fit in this circumscribed market and offer services currently provided by FMIs. To dive in this game, Prime Brokers would have to integrate post-trade infrastructure to their platforms, adopt internal controls to curb conflicts of interest, allow traceability of trades and post-trade activities and enforce a set of common rules and procedures binding all participants in their platforms.
In other words, opportunities generate regulatory burdens as well. Prime Brokers can be a competitive alternative to FMIs but will necessarily have to endorse (i) transparent governance arrangements, (ii) a sound risk management framework for dealing with numerous matters and (iii) efficient matching of buyers and seller at stock exchange prices, amongst other important factors.