European participants waiting for an improvement in fixed income transparency before returning to the market will have to wait longer than expected, after the Council of the European Union postponed its internal Mifid II debate while the presidency moved from Cyprus to Ireland at year-end.
Michel Barnier, EU Commissioner for internal market and services, and Parliament have finalized their versions of the new rules, but a trilogue debate between all three branches of the European government on the Mifid II is now not expected until the end of the second quarter.
With protracted uncertainty taking its toll on market confidence on both sides of the market, banks are eager for clarity in two key areas, the outcomes of which could change the way they engage clients, execute transactions and conduct their fixed income business generally.
According to Fiona Syer, senior manager with the Deloitte EMEA Centre for Regulatory Strategy in London, if poorly calibrated, Mifid II’s post-trade transparency requirements could substantially reduce market liquidity. While some fixed income markets are deep and widely traded, such as cash investment-grade corporate bonds and vanilla US dollar interest-rate swaps, others are not.
“Forcing market participants to disclose information on traded prices and volumes in thinly traded markets will impact liquidity," she says. "From an over-the-counter (OTC) derivatives perspective, the instruments which will be subject to a mandatory trading obligation, and the definition of what constitutes an eligible venue for the trading of these instruments will be key. Products must exhibit a certain degree of market liquidity to successfully support venue trading and this is far from certain for a large proportion of the OTC derivative market.”
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| Michel Barnier, EU Commissioner for internal market and services. Source: Reuters |
Indeed, bankers and market participants continue to fret about the definition, or lack thereof, of what constitutes an eligible trading venue. Although the rules are intended to close the regulatory gap between the OTC trading that occurs bilaterally between desks or within dealer crossing networks and that on organized trading facilities (OTFs), European regulators have failed to make proposals that reflect how the market operates. Early drafts of the OTF rules included the provision that facility operators might not execute client orders against their proprietary capital, which would appear to bar banks from establishing OTFs to continue their fixed income trading business. Obviously, this would require a fundamental review of how sell-side institutions are set up to operate in the fixed income markets.
Of course, the industry has pushed back vehemently on these proposals and it is expected that final rules will be watered down dramatically. While regulators pause for the presidential rotation, however, there is some indication that they are aware, at least, of banks’ concern. “The negotiations are still ongoing but there are some helpful provisions," says Syer. "In particular, the commitment that Esma [European Securities and Markets Authority] will not copy and paste the equity post-trade transparency requirements across to non-equity products is an encouraging sign. As too is the commitment to calibrate the regime by individual asset class."
Current efforts are focused on stripping out regulatory provisions that would require banks to effectively rebuild their fixed income operations while watering down the drive for pre-trade transparency, but behind the scenes new ventures are looking for ways to exploit the forthcoming market fragmentation with aggregation models.
Stu Taylor, CEO and co-founder of Algomi, a London-based technology platform supplying a number of global banks, argues that as the OTF and trade transparency rules fragment traditional fixed income liquidity pools, new solutions will emerge. “We are seeing new businesses starting up the same way as we saw them come up under Mifid I," he says. "Banks are setting up in-house aggregation businesses for the benefit of their clients and their market-making desks, and simultaneously we are seeing a range of new non-bank start-ups seeking to penetrate the market as a consequence of the new rules.”
Despite the protestations of the banking community, Taylor is confident that Mifid will not worsen the liquidity crisis in European fixed income. “Banks will need to invest in connecting to additional venues, but Mifid is not the driver of crisis," he says. "For sure, liquidity will have to be sourced and provided to clients in a smarter way, but as we have seen in other asset classes, algorithms can play a positive role in applying risk and sourcing liquidity to help smooth out some of the volatility.”
What is clear, however, is that we are entering a new phase of competitive differentiation in fixed income – the gulf between those banks and platforms that adapt and those that don't will become clear within 24 months.