Market Makers Under Fire As Bilateral Trading Sweeps Wall Street

The rise of bilateral trading workflows has been a game-changer for buy-side traders and market participants alike. The shift towards direct, electronic connections between buyers and sellers has led to increased efficiency, reduced market impact, and improved liquidity. However, this natural evolution also raises concerns about the potential long-term implications on public markets.

Bilateral trading involves the use of Electronic Market Makers (EMMs) or other types of non-displayed liquidity providers to facilitate trades directly with clients’ Execution Management Systems (EMS). This approach has gained significant traction among buy-side firms and is now being offered by major sell-sides as well. The benefits include:

1. Reduced market impact: By directly connecting buyers and sellers, the need for intermediaries decreases, which can lead to reduced trading costs or commissions.
2. Better liquidity: Direct flow from bilateral providers would increase liquidity levels in this part of the market, potentially leading to more comprehensive systems.
3. More efficient workflows: The elimination of intermediaries means faster execution.

However, there are also some drawbacks to consider:

1. Increased dependency on third-party firms and potential regulatory intervention if they have concerns about market structure changes. Regulators may need to keep pace with technology advancements without imposing costs or burdens on development.
2. Complexity in the regulatory environment: The growth of bilateral trading poses a challenge for regulators, who must balance oversight with the need to promote efficiency and reduce barriers to entry.

The European Securities and Markets Authority (ESMA) and the Financial Conduct Authority (FCA) have already taken steps to regulate market structure changes. The FCA introduced Mifid II in 2020, aiming to improve market transparency and reduce fragmentation. However, regulating unilateral market makers’ activity in bilateral systems may require further action.

Regulators could focus on improving market transparency by enhancing reporting requirements for Electronic Market Makers (EMMs) and other liquidity providers. This would involve clearer flagging mechanisms and increased data availability on market making activities, helping to ensure that participants are held accountable for their actions.

While more data is needed to fully understand the impact of bilateral trading, regulators can take steps to promote transparency and efficiency without stifling innovation. The key question is how far regulators should go in regulating unilateral market makers’ activity in these systems to strike a balance between promoting efficiency and reducing market risks.