Capital Markets Advisors

Turning Change Into Opportunity


IFR 2043 26 July to 1 August 2014
By Christopher Whittall


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 & Overy. “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.”

Daily reporting

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

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.

Data gathering

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.”

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