LONDON Feb 25 The European Union's securities watchdog said it will tread carefully in regulating government and corporate bonds to avoid crimping liquidity in already fragile markets that are key to funding economic growth.
Verena Ross, executive director of the European Securities and Markets Authority (ESMA), said changes to market practices were inevitable under new EU rules in 2016.
Many bonds are traded privately but under the rules, known as MiFID II, traders would have to post prices to the wider market - a step critics say will force some banks to only trade the most popular bonds as it would be harder to make a market in less liquid ones.
Ross said ESMA was, however, mindful of the need not to damage liquidity which it acknowledges is already under pressure.
Issuance of sovereign bonds in Europe in the second half of last year fell to 429 billion euros, its lowest level since the height of the financial crisis in 2008.
"It is clear that liquidity in bond markets is still pretty fragile and that ESMA's regulatory framework may have a role in order to safeguard the functioning of this market," Ross told a conference organised by the Association for Financial Markets in Europe (AFME), a banking lobby, on Tuesday.
ESMA will face political as well as industry pressure to go easy on corporate bonds as politicians look for ways to boost trading in a bid to reduce companies' reliance on banks for funding.
Poor liquidity in corporate bonds is already prompting policymakers to look at alternative ways of funding companies, such as by reviving securitisation or pooling of loans into bonds.
Ross said market practices and possibly their structures will change as a result of the new transparency requirements aimed at giving investors more information and allowing regulators to see what is going on in the market.
"I know some of you are concerned about this but things cannot stay as they are today," she said.
ESMA's first task will be to define liquidity so that it can then determine which bonds are subject to the transparency rules, but so far no single definition has emerged. Bonds deemed illiquid would get waivers or be exempt from some rules.
Ross sought to reassure bond traders in the audience that current tough transparency rules for shares would not be "mechanistically" applied to bonds.
Rick Watson, AFME's head of capital markets, said Ross' speech made it clear the watchdog recognises the important differences between equity and bond markets and that it plans to calibrate liquidity based on fixed income specific data.
ESMA also recognised that fixed income markets will "require a flexible and dynamic approach to calibration and waivers thresholds", Watson said.
The watchdog will monitor the liquidity of bonds regularly once the new rules are in force, meaning that if a bond becomes less liquid over time as many do, they could be exempt later on from the toughest transparency rules.