(This story originally appeared in International Financing
Review, a Thomson Reuters publication)
By Christopher Whittall
LONDON, Aug 4 (IFR) - As a consultation on landmark reforms
that will irrevocably change the face of European financial
markets draws to a close, a fundamental and deceptively simple
question remains at the centre of the regulatory debate: how to
define market liquidity.
At stake is the range of products that will be captured by
beefed-up pre and post-trade transparency requirements under the
EU's Markets in Financial Instruments Directive and channelled
into organised trading facilities - the equivalent of the US's
swap execution facilities.
The end result will have far-reaching consequences, with
MiFID II establishing new standards for trading the full gamut
of financial instruments - from structured products, to
corporate bonds, to OTC derivatives.
"MiFID is so aggressive and life-changing in all respects,
particularly the transparency piece in terms of the impact on
market structure," said Damian Carolan, partner at Allen &
"Dodd-Frank was largely about derivatives - the rest was
already embedded. Europe has taken all that it knows and loves
about equities and applied it to everything so they can say they
have best of breed for all financial instruments."
MiFID differs from Dodd-Frank in more than just the scope of
its remit. US regulators opted for a top-down approach when
designating which swaps should trade on SEFs, setting a coverage
ratio of 67% of the total market.
Exactly which instruments make the leap to SEFs is mainly
dictated by market forces - platforms submitted "Made Available
for Trade" applications for the CFTC to rubber stamp - and has
been viewed as generally successful.
European Securities and Markets Authority is taking a more
prescriptive approach by deciding for itself which instruments
should be traded on multilateral platforms. To do this, the
regulator is examining a range of criteria, including average
frequency and size of trades, the amount of participants trading
in a product and the width of bid/offer spreads. Even so, the
body looks to have its work cut out.
"Liquidity is a fundamental concept that has been
preoccupying not only regulators but market participants for
some time," said George Handjinicolaou, deputy CEO of ISDA. "It
can be elusive - something can be liquid today and not tomorrow,
particularly during periods of market stress."
For those instruments deemed liquid, the current ESMA
proposals require information on pricing, the size and the time
of the trade to be published publicly within five minutes of
execution. These products would potentially have to be executed
on a multilateral trading facility.
In contrast, illiquid instruments would stay off-exchange
and trading information would not have to be reported until the
end of the following day. Where the regulator draws the line
will have profound consequences for market-makers.
"If the liquidity thresholds are set too low, therefore
requiring trade data on less liquid instruments to be published
within, say, five minutes of the transaction taking place, then
dealers may be wary of making markets knowing their positions
will be revealed," said Handjinicolaou.
ISDA is gathering data from the DTCC on the average trading
frequency and size of various derivative contracts to feed into
ESMA's analysis. Participants hope MiFID will ultimately end up
capturing roughly the same product set as Dodd-Frank, including
standardised interest rate swaps in major currencies out to 30
years and on-the-run CDS indices.
ISDA has previously highlighted a 2010 study from the
Federal Reserve Bank of New York that found around 4,300 of the
10,500 combinations of swaps across various currencies and
maturities only traded once in a three-month sample period.
In contrast, the most liquid interest rate swaps changed
hands up to 150 times each day. Many see standardisation as an
inevitable outcome of the latest reforms.
"MiFID will drive further standardisation of OTC swaps at
the cost of bespoke, longer-dated contracts." said Bradley Wood,
a partner at Greyspark Partners. "There's a good chance the
additional liquidity benefits that will come to standardised
contracts could offset the lack of bespoke contracts for
investors' hedging needs."
"The downside of attempting to define liquidity [for
European regulators] is that they have to monitor the liquidity
situation going forward, and it's not clear if they have the
ability to do that," Wood said. "They might have bitten off more
than they can chew."
(Reporting by Christopher Whittall, Editing by Matthew Davies)