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WorldJanuary 26 2015

MiFID Christmas present threatens bond market hangover

A sweeping overhaul to EU rules on bond market transparency could aggravate a liquidity shortage in secondary trading.
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What is it?

Days before Christmas 2014, the European Securities and Markets Authority (ESMA) published more than 1600 pages of consultation on the regulatory and implementing technical standards for the Markets in Financial Instruments Directive and Regulation (MiFID II/MiFIR). One of the most crucial new pieces of information was the approach that ESMA has chosen to define whether non-equities such as bonds are liquid.

If they are, then trades in these instruments face full pre- and post-trade transparency, depending on the size of the individual transaction. In an earlier consultation in May 2014, ESMA had set out the choice between an instrument-by-instrument approach (IBIA) and a class of financial instrument approach (Cofia) to defining liquidity.

Which way did they jump?

With about 900,000 individual fixed-income instruments trading in the EU, the regulator has decided that the data requirements for the IBIA are unmanageable, and confirmed in December that it has opted for Cofia. ESMA has set out 12 classes of instruments, of which three (structured financial products, non-financial convertible bonds and others) are considered illiquid in general. Of the remaining nine, ESMA has set thresholds for liquidity based purely on original issuance size – ranging from €2bn for sovereign bonds to €500m for senior financial and subordinated bonds.

“This is a blunt tool, with too many illiquid instruments being classified as liquid – as much as 43% to 74% of each asset class category,” says Sidika Ulker, director of capital markets at the Association for Financial Markets in Europe (AFME).

Changing their tune?

In its original May 2014 consultation on MiFID, ESMA set out six scenarios for identifying whether a bond is liquid. The market consensus was that the sixth scenario was the most realistic, says Jim Rucker, global head of operations at trading platform MarketAxess.

This scenario envisaged an instrument that traded 600 times per quarter, on at least 30 days per quarter (hence an average of 20 trades per day), and with average daily turnover of at least €1m. By contrast, ESMA says its chosen definition by issue size equates to a liquidity threshold of two trades per day, 400 trades per year, and average daily turnover of just €100,000.

“Our list of liquid bonds includes only a few corporate issues, and it changes every quarter. Bonds tend to be most liquid immediately after issuance or due to event-driven trading, so liquidity status needs regular review, but ESMA’s definition would be static,” says Mr Rucker.

What price transparency?

Reg rage - exasperation

If bonds are deemed liquid under these rules, and if a trade is below the set size specific to the instrument SSTI defined by ESMA, then the trade must have full pre- and post-trade transparency. Market participants warn that this level of pre-trade transparency on instruments that trade so infrequently poses serious risks for dealers and investors, because it can move the price ahead of execution.

“If dealers are required to trade illiquid instruments in a fully lit pre- and post-trade environment, they will either stop offering pricing on these instruments or offer it only at a bid/ask spread wide enough to price in the risks, which will mean higher costs for investors and issuers,” says Frederic Jeanperrin, managing director responsible for MiFID implementation in Société Générale’s global markets division.

What’s the alternative?

Andrew Bowley, head of European market structure at Nomura, contrasts the European Commission’s approach to secondary markets in MiFID with the UK’s Fair and Efficient Markets Review (FEMR) announced in October 2014. The very long EU policy-making cycle means that the list of major concerns in fixed-income markets has moved on since MiFID II was first under discussion. Poor market liquidity is now top of that list, as highlighted in the Bank of England’s Financial Stability Report in December 2014, which referred to “a decrease in dealers’ inventories and a retreat from market-making”.

“[Former European Commissioner] Michel Barnier made clear in January 2014 that the European Commission would have liked to push further toward transparency in the level-one text. It is noticeable that the UK FEMR has more of a sense of balance between transparency – the fairness aspect – and liquidity – the efficiency. Perhaps it will be possible for that thinking to feed into the European Council and European Parliament approvals process for MiFID during the second half of 2015,” says Mr Bowley.

Now that ESMA has gone down the Cofia route, however, Ms Ulker is unsure how much the regulator can do to improve the final outcome, because the fixed-income universe is so heterogenous compared with the ESMA definitions. The issue size threshold and underlying liquidity test assumptions could be reviewed, and an increased granularity to the list of classes might help.

“To reach a level where at least 90% of the bonds classified as liquid under MiFID really are liquid for practical purposes, some other criteria are needed such as ratings or time to maturity. There should be further study of this,” says Mr Jeanperrin.

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