MiFID II/R Draft regulatory technical standards on

MiFID II/R
Draft regulatory technical standards on
transparency requirements in respect of bonds
A briefing note: May 21 2015
Key objectives of MiFID II/R
Move more OTC trading onto trading venues through a trading obligation for certain
equities and derivatives and establishing a new type of trading venue for non-equites: the
Organized Trading Facility (OTF). Systematic Internalizers will also become more
important for bond trading.
Increase transparency through expanding pre- and post-trade transparency
requirements for non-equity instruments.
Promote orderly markets by introducing specific provisions for algorithmic and highfrequency trading.
Improve oversight and transparency of commodity derivative markets to reduce systemic
risk and speculative trading.
Promote competition in trading and clearing markets by requiring trading venues and
CCPs to provide non-discriminatory and transparent access to one another.
Objective of transparency requirements for non-equities
Aims to ensure that investors are adequately informed as to the true level of actual and
potential transactions.
Applies to transactions on regulated markets, multilateral trading facilities, organized
trading facilities, systematic internalizers, or outside those facilities.
A high degree of transparency is essential to ensure a level playing field between trading
venues so that the price discovery mechanism for various instruments is not impaired by
fragmented liquidity, and investors are not thereby penalized.
However, the regulation recognizes that there may be circumstances where exemptions
from pre-trade transparency obligations, or deferral from post-trade transparency
obligations, may be necessary.
The new market structure paradigm
Regulated Market (RM)
A multilateral system operated by and/or managed by a market operator, which brings together or facilitates
the bringing together of multiple third-party buying and selling interests in financial instruments.
Multilateral Trading Facility (MTF)
A multilateral system, operated by an investment firm or a market operator, which brings together multiple
third-party buying and selling interests in financial instruments.
Organized Trading Facility (OTF)
A multilateral system which is not an RM or an MTF and in which multiple third-party buying and selling
interests in bonds, structured finance products, and derivatives. Unlike RMs and MTFs, operators of OTFs will
have discretion as to how to execute orders, subject to pre-trade transparency and best execution obligations.
Systematic Internalizer (SI)
An investment firm that deal on its own account by executing client orders outside a trading venue.
RMs and MTFs are not allowed to execute client orders against proprietary capital, or to engage in matched principal trading.
OTFs may deal on own account other than matched principal trading only with regard to illiquid sovereign debt instruments.
OTFs and SIs cannot exist within the same legal entity, nor connect to enable orders or quotes to interact.
Transparency requirements: pre-trade
Applies to RMs, MTFs, and OTFs
Operators must make publically available, on a continuous basis during trading hours,
actionable indications of interest (IOIs); i.e. current bid and offer prices, and depth of
trading interest .
This includes Request For Quote (RFQ) systems and voice trading systems
Waivers:
» Financial instruments for which there is not a liquid market
» Orders that are large in scale (LIS) compared to normal market size
» Orders on RFQ or voice trading systems that are equal to or larger that the relevant size
specific to the instrument (SSTI)
» Orders held in an order management system
Pre-trade transparency
Trading
venue?
Large
trade?
Liquid?
RM, MTF,
OTF
Liquid
LIS
RFQ, Voicebroked
Liquid
SSTI
Other?
OMF
v
Trade
LIGHT
Off-venue
DARK
Transparency requirements: post-trade
Applies to RMs, MTFs, OTFs, and investment firms.
Investment firms trading outside a trading venue and market operators and investment
firms operating a trading venue, must make publically available trade details, including
price and quantity.
Post-trade information must be available as close to real time as possible (within 15
minutes of execution up until Jan 2020 and within 5 minutes thereafter).
Reporting can be deferred for up to 48 hours in the case where:
» The transaction is in a security for which there is not a liquid market
» The size of the transaction is equal to or exceeds the relevant large is scale size (LIS)
Under certain circumstances, a supplementary deferral regime grants relevant NCAs the
authority to aggregate the trade details of several transactions, or omit publishing the
size of an individual transaction, for an extended deferral period of 4 weeks.
Where a class of instrument suffers a significant reduction in liquidity, the relevant NCA
can temporarily suspend transparency requirements for that class (for up to 3 months).
Post-trade transparency
Trading
venue?
Liquid?
RM, MTF,
OTF
Liquid
Large
trade?
LIS
REALTIME
Trade
Investment
Firm, incl. SI
Liquid
LIS
DEFFERED
Liquidity assessment
Underlying pre- and post-trade reporting obligations is whether or not a security is
deemed ‘liquid’.
MiFID II/R sets out a definition for ‘liquid’ securities, including bonds.
Level 1 defines a liquid market as a market for financial instruments or class of
instruments for which there are ready and willing buyers and sellers, taking into
consideration the average frequency and size of transactions, the number and type of
market participants, and the market spread. This implies an instrument-by-instrument
approach (IBIA) to calibrate liquidity based on a number of factors.
For non-equities, Level 2 proposes a definition based on a class of financial instrument
approach (COFIA). In the case of bonds, this is defined purely by issuance size relative to a
variety of sub-classes of bonds.
The LIS and SSTI waiver and deferral thresholds are also defined using the same COFIA
model.
Bonds – liquid classes
Bonds – classes not having a liquid market
Liquidity assessment: ‘False positives’
Using ESMA’s COFIA calibrations for bonds in the Level 2 RTS means that many individual
bonds which would have been classified as illiquid applying the Level 1 IBIA framework
will now be classified as liquid.
Under the Level 2 approach, and based on ESMA’s own data (provided by NCAs) and
analysis, between 40% and 74% of bonds will be incorrectly defined as liquid.
Analyses by others using TRAX data suggest even higher incidents of ‘false positives’.
This presents a problem for market-makers, who will be subject to pre- and post-trade
transparency requirements on a significant number of instruments that are technically
illiquid.
ESMA arguments for COFIA:
»
»
»
»
Will provide market participants with stability and predictability
Much less complex than IBIA
Liquidity status of new issues can be determined easily
LIS and SSTI exemptions will mitigate potential adverse impact on liquidity
ESMA’s COFIA segmentation assessment
ESMA’s COFIA segmentation assessment: ‘false positives’
ISINs below liquidity threshold
80.00%
70.00%
60.00%
50.00%
40.00%
30.00%
20.00%
10.00%
0.00%
EU Sovereign
Bonds
Other
Covered Bonds
European
Public Bonds
Senior
Corporate
Bonds
(Financial)
Senior
Corporate
Bonds (NonFinancial)
Subordinated
Corporate
Bonds
(Financial)
Subordinated
Corporate
Bonds (NonFinancial)
Convetible
Bonds
(Financial)
Market concerns
Market-makers will be reluctant to provide liquidity in illiquid securities that are defined
as liquid under the regulation. This would be detrimental to bond market liquidity,
resulting in wider bid-ask spreads and fewer executionable prices.
ESMA’s analysis to determine LIS and SSTI thresholds does not take into account trades
below EUR 100k. This skews the thresholds to higher than appropriate values.
The proposed post-trade reporting deferral of 48 hours is inappropriate for transactions
in illiquid securities, and will expose market-makers in these instruments to unwarranted
market risk.
The MiFID II/R liquidity definitions contradict prudential regulatory liquidity definitions,
such as FRTB and LCR.
• E.g. FRTB assumes that it would take 20 days to liquidate an exposure in sovereign bonds
without moving the market, whilst ESMA assumes that 100% of sovereign bonds are liquid.
• E.g. LCR assumes that it would take 120 days to liquidate a high yield bond, whilst ESMA
assumes that 55% of high yield bonds are liquid.
ICMA Recommendations
ICMA created an industry Working Group consisting of senior traders from both sell- and
buy-side members to structure its response to the Level 2 Consultation Papers.
The WG proposed a ‘hybrid’ liquidity calibration model which incorporates elements of
both IBIA and COFIA. This combines the simplicity and predictability of COFIA with the
necessary granularity of IBIA.
Data inputs include daily average spread* (the ‘liquidity gate’), issuance size, and time
since issuance.
The WG further proposed an alternative model, which is effectively a more granular
COFIA model, but with tiered LIS and SSTI thresholds (the calculations for which include
trades below EUR 100k).
The response also argued for a supplementary post-trade deferral period longer than 4
weeks (up to 12 weeks), and pointed out that a COFIA model was inappropriate for
determining temporary reporting suspensions.
* Within a 4bp bid-ask spread on a 90-day rolling average basis
MiFID II/R timeline
•
•
Q3: ESMA final technical standards
Q3 2015/ Q1 2016: implementing measures
finalized
•
Q1: MiFID II/R takes effect
Conclusion
While ICMA welcomes greater transparency in the bond markets, it is concerned by the
proposed liquidity calibrations for pre- and post-trade under MiFID II/R, which are not fit
for purpose.
The likely outcome is that investment firms will be deterred from dedicating capital to
support market-making is a significant number of bonds that are incorrectly classified as
liquid by the regulation.
This will result in wider bid-ask spreads and thinner markets for many securities.
This will increase costs and risks to investors who will find it increasingly difficult to
unwind bond holdings.
Ultimately, this could result in higher borrowing costs for issuers (both private and public).
The unintended consequence of further deteriorating bond market liquidity is not only a
cost to the real economy, but also flies in the face of the objectives of CMU.
Contact
Elizabeth Brooks Callaghan
[email protected]
+44 (0)207 213 0313