European regulators are acutely aware of the need to safeguard and improve the depth of liquidity in fixed income and foreign-exchange markets, as new trading and clearing regulations are implemented over the coming years, according to a senior official at the European Securities and Markets Authority (ESMA).
Speaking at the European Market Liquidity Conference yesterday, hosted by the Association for Financial Markets in Europe, Verena Ross, ESMA’s executive director, told delegates the authority has had many “very difficult” discussions about liquidity since ESMA was created three years ago to steer the implementation of post-crisis reforms.
In particular, concerns have been raised over the impact the second iteration of the Markets in Financial Instruments Directive (Mifid II) – which will create new rules for trading and transparency in derivatives – could have on liquidity.
“There are endless debates of the relation between transparency and liquidity, and whether there is a trade-off between them,” said Ross. “We tend to see the Mifid II mandate as one aimed at increasing transparency in a manner that does not damage, but improves, the functioning of the market.”
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| Verena Ross, ESMA’s executive director |
The first version of Mifid came into force in 2007, but concentrated mainly on trading practices in the equity markets. The Mifid II text was unveiled by the European Commission in October 2011, and the European Parliament and Council reached agreement on the rules on January 14. Once the final text is approved, ESMA will be responsible for consulting with the industry to develop technical standards for implementation.
“We are aware of the significant impact that our future regulatory work under Mifid II may have on liquidity within EU financial markets,” said Ross. “But this is not a completely new element of our work.
“We already monitor and assess today securities markets in order to identify trends, potential risks and vulnerabilities, and report comprehensively on these issues on a regular basis.”
During panel discussions at the conference, concerns over the impact of regulation on market liquidity arose repeatedly among industry participants.
Robert Stheeman, chief executive of the UK Debt Management Office, said there has been little negative impact so far, but it remains a major concern for debt managers.
“We are constantly on our guard to see what development there might be that could potentially impact negatively on liquidity,” he said. “Debt management offices have relied and rely still on the market as the fundamental mechanism through which we fund ourselves.
“We don’t have any other model of distributing debt other than the market, so from our perspective, the maintaining of liquidity in the future is of critical importance. Liquidity is something close to a public good.”
The UK sovereign bond market remains the exception rather than the rule.
In the FX market, non-deliverable forwards (NDFs) have been affected since the launch of swap execution facilities (SEFs) under the US Dodd-Frank Act on October 2.
Although NDFs are not yet mandated to trade on SEFs, multi-dealer platforms were nonetheless required to immediately register as SEFs, which some believe has had an adverse effect on the market as liquidity is split into pockets.
“Liquidity has been hurt very badly with what’s happened,” said Chris Eagle, head of European FX sales at Jefferies. “We’ve already seen the scattering to the winds. There is inherent instability in the markets we trade in and we see it from price action every day.”
Some participants believe the market fragmentation is a result of the lack of central clearing for FX derivatives.
Following intensive industry lobbying after the passage of the Dodd-Frank Act in 2010, the US Treasury exempted FX swaps and forwards from mandatory clearing and exchange trading – a move that regulators in other jurisdictions have pledged to follow.
Meanwhile, some clearing houses have started offering clearing of NDFs, but there is not yet a mandate for clearing the product, and the industry is still working to find a clearing mechanism for FX options.
“Many of these issues are a consequence of not having central clearing,” said Paul Tivnann, global head of FX and commodities electronic trading at Bloomberg. “We’re dealing with a very bespoke bilateral market in foreign exchange that is subject to many complex bilateral agreements between banks and customers.
“From our practical experience, there are still major banks that are not pricing customers over SEFs, there are banks pricing on some SEFs and not others, and some banks pricing some clients and not others. So by definition there is a fragmentation of liquidity.”