LONDON, April 20 (IFR) - As the sweeping reforms contained in the so-called MiFID II proposals creep closer to being incorporated into European regulations, bond specialists are preparing for a fundamental shift in fixed-income markets.
The reforms, which are designed to make European bonds trade more like equities, might batter liquidity levels - and slash the number of bond traders employed by banks - but could create new opportunities for exchanges and agency brokers.
At the end of last year, the European Commission finalised a legislative proposal for MiFID II, seeking to extend the transparency of equity markets to asset classes such as bonds, commodities and derivatives. The regulation is still before the European Parliament, and is likely to be significantly amended before it is introduced, but its implications are profound.
"If the regulation in its current form is approved, it will have a drastic impact on the world of fixed-income trading," said Christian Krohn, managing director at the Association for Financial Markets in Europe.
Another industry observer said that the introduction of MiFID, combined with other interlocking regulatory and commercial challenges in the international capital markets, meant the industry was facing changes as drastic as the "Big Bang" reform of UK equities in the 1980s.
DEVILS AND DETAILS
In a study published last month, TABB Group's director of fixed income Will Rhode argued that the new rules would place onerous burdens on market-makers and hinder their ability to warehouse risk.
A fully transparent trading regime for assets without ready buyers or sellers means the market will know what price other dealers paid for positions - and therefore how vulnerable that position is. This will effectively prevent dealers holding large inventories of illiquid assets, rendering them even more illiquid.
Roger Barton, a regulatory expert at MTS, said that regulators were aware of this problem. "It's not going to be the case that every bond moves overnight on to a fully electronic, regulated and transparent exchange," he said. "Some bonds will be less suitable for that move, and the degree of transparency still needs to be calibrated."
This calibration - likely to be delegated to the European Securities and Markets Authority after the European authorities pass the primary legislation - will determine how tough MiFID is in practice.
If regulators set the volume bar low, banks will only have to make public and transparent markets in small size, protecting their ability to execute large volumes at undisclosed prices. Raising the required volume at which a bank has to make firm public markets will discourage dealers from being active in less liquid securities.
Few banks would want to provide a public market for EUR50m each way in a deal with EUR200m outstanding, for example, but could be happy to provide transparent prices when it comes to a EUR5m clip in the same security.
The draft of MiFID says only that the volume calibration will be based on "normal" volumes in particular markets - but ESMA's interpretation of "normal" could inhibit liquidity in certain assets if it is set too high. And certain sectors could be hit particularly badly, such as derivatives.
"The proposal is that if a derivative is considered to be sufficiently liquid by ESMA, which is quite a technical test in itself, it will only be allowed to be traded on regulated markets. Realistically, that is likely to mean the range of derivative products will be condensed," said one capital markets partner at a law firm.
Some assets could win exemption from the new rules, but that is unclear too. "The regulators have the ability to apply waivers to exempt some of these instruments from the transparency requirements in certain circumstances, but it is unclear exactly how and when those waivers will be applied," he said.
MAN VERSUS MACHINE
But as the window shuts on one aspect of the market, it is poised to open for another. Agency brokers may be able to claw back market share as traditional buy-side firms move away from holding bond inventories, in a mirror of 2008 when the market faced a similar situation of banks shedding bond holdings.
Strategists are also predicting the emergence of electronic platforms, enabling trading through so-called all-to-all matching models.
The French finance ministry has been trying to kick-start such an equity-style exchange-like framework since 2010 through the Cassiopeia Committee.
This relies on a consortium of buy-side firms, enabling European corporate bonds to trade through secondary market platforms, on a peer-to-peer basis.
MTS Credit, NYSE Euronext and TradingScreen have supported the Cassiopeia initiative by launching trading platforms.
"I think exchanges like this will really pick up in the face of new regulations, and in response to this it would not surprise me if banks started to cut the number of traditional corporate bond traders they have," one fund manager said.
He said he was aware of some major financial institutions already considering streamlining their trading departments, in anticipation of technology taking over.
However, one head of ABS trading said that more transparent pricing and electronic trading would play into the hands of the largest flow banks, with agency brokers struggling to compete.
"Once everyone can see everyone else's prices, you need to add value in other ways. That means depth of relationships, sales coverage, supporting your trading operation with research. The large banks will retain or even consolidate their position."
Other observers highlighted secular trends moving in the same direction.
"Some of the main MiFID changes are really the continuation of decades-long trends," said Barton. "Automated back office systems, electronic order platforms and increased commoditisation of bond trading have all been trends for 20 years. The MiFID review will give this a push, but it isn't new."
Although the impact of MiFID will undoubtedly be severe, market players point out that the introduction of the new framework is still some way off and may still undergo significant changes before it is finalised. (Reporting by Josie Cox, Owen Sanderson and Anil Mayre. Editing by Matthew Davies)