Some seeing problems with transparency rules on fixed-income trading
Bond market liquidity and the fixed-income investing business could be affected by new transparency requirements under the incoming MiFID II rules, warn money management and association executives.
The Markets in Financial Instruments Directive II, effective Jan. 3, will put new pre- and post-trade transparency demands on certain fixed-income trades such as those deemed liquid and below a certain size.
"One of the interesting developments from the introduction of MiFID II is the introduction of the transparency of fixed-income trades," said Gary Kirk, London-based partner and portfolio managers of the Strategic Income Fund at TwentyFour Asset Management LLP. "Effectively, moving forward, full transparency of participant flow and direction will be posted after every trade, and this is going to be a useful development. At the moment when we do a trade with a counterparty, only we (and the counterparty) know about the size, direction and price of that trade. However, going forward all this information will be posted and we will be able to get ongoing information about all trades taking place in the bonds that we have a care in."
Sources are split on whether the transparency push will affect market liquidity in a positive or negative way.
Speaking last month on a panel regarding regulation at Pensions & Investments' WorldPensionSummit in The Hague, Netherlands, Jack Inglis, CEO at the Alternative Investment Management Association, voiced his concerns.
"I think liquidity in the corporate bond market has already been hit fairly significantly just by Basel III capital requirements — so that banks that have traditionally been providers of liquidity to the marketplace, warehousing inventory, have much-reduced capacity. We're aware of that … it definitely has dropped. What does MiFID II do, then — does that bring even further challenges to liquidity? And I would suggest that it does."
Mr. Inglis said pre- and post-trade transparency requirements, and the definitions around what bonds are deemed liquid and illiquid by regulators, might cause problems in particular. "I think there's some confusion out there, and I think all that confusion is going to lead, unfortunately … potentially (to) even less liquidity," Mr. Inglis said.
Said Chris White, CEO at BondCliQ in New York: "The MiFID II methodology for transparency will have a negative impact on the commercial prospects for market makers, which will ultimately impair bond liquidity. The MiFID II approach forces market makers to provide proprietary pre-trade information, but does not create the necessary environment to link customer order flow to the price-making capabilities of the dealers. Outside of regulatory compliance, market makers, who are critical to maintaining well-functioning markets, are not incentivized to improve market transparency and provide liquidity."
Liquid vs. illiquid
MiFID II stipulates that only those bonds deemed liquid by the European Securities and Markets Authority are subject to pre- and post-trade transparency. Waivers to pre-trade transparency are granted in certain circumstances, such as for larger orders.
"There will be some (managers) with deeper pockets with a better ability to trade large and at scale, so the use of waivers (regarding what is required to be reported and when) will be important," said Patrik Karlsson, director, market practice and regulatory policy at the International Capital Market Association in London. "The liquidity thresholds are important because a very large percentage of outstanding bonds will be deemed illiquid — therefore (market participants) can mask these trades and not (make them) public. At least large asset managers will be able to continue trading on a basis that doesn't leak information to the market."
Regarding these thresholds for making public information, Nick Robinson, head of trading at Insight Investment in London, said there had been a marketwide concern that pre-trade thresholds for bonds would be set "quite high, which could have impacted market makers' willingness to make markets in less liquid products.
"However, we feel the thresholds have been set at realistic levels — as have the MiFID II definitions of liquid and illiquid bonds — and will therefore not impact liquidity provision," Mr. Robinson said.
"Perhaps the greatest impact of the transparency requirements will be an increased use of electronic trading platforms, particularly so for smaller and more liquid fixed-income products," Mr. Robinson added.
The transparency push will have a greater impact on those bonds deemed liquid than illiquid, sources said.
"There are two buckets — liquid and illiquid" fixed income, said Chris Perryman, head of trading, emerging markets fixed income at PineBridge Investments in London. "Illiquid markets aren't going to materially change to start with. … An illiquid bond isn't set up for the dominant style of electronic trading — request for quote. We will negotiate the trade to the point where we have the best price, liquidity and outcome for the client," but the actual trade will take place within a multilateral trading facility — a trading venue. Mr. Perryman thinks dark pools also will be used more, although "there is not historic traction there in fixed income."
The "big, material change" will come in liquid fixed-income instruments. "What perversely could happen because of the reporting requirements is bigger tickets take better prices, and there will be a delay in reporting. A bigger block doesn't get reported for a number of days or weeks," and a sell-side counterparty might be "more inclined to do that from a position where there is no information leakage. Most asset managers will probably try to bundle up trades to bigger sizes to get better prices," Mr. Perryman said.
He said he thinks January will be a challenging month as the market will need to understand the rules and use them.
"Liquidity initially will be cautious and therefore lower, and as we get used to (the new situation) it will return to normality," Mr. Perryman said, but with a smaller number of counterparties and increased ticket sizes in liquid bonds, and a greater number of counterparties and "nimble" ticket sizes in illiquid instruments.
However, as with concerns over the availability of fixed-income research, sources said there might be a longer-term benefit to liquidity.
"Over the medium to long term, the new transparency regime could be good. As more data become available, the information will become better and better, and the market may be able to move more bond trading to electronic venues over time," Mr. Karlsson said.
"Hopefully, the initial crunch from Jan. 3 shouldn't be too terrible," he added.
TwentyFour AM's Mr. Kirk added: "From a trader's perspective, having greater transparency about the market flow should result in them being able to, or at least prepared to, offer greater liquidity to clients. I don't know if this will happen, but I think it is going to be a help. So I can't guarantee MiFID II will drive greater liquidity, but it isn't going to hinder it — and so overall we are encouraged about its impact on liquidity moving forward."
Some money managers have been developing internal tools to increase visibility in pre- and post-trade areas. "Such requirements also support our clients' needs to understand how we are making decisions and acting in the market," said Spencer Woodward, director of investment operations at BlueBay Asset Management LLP in London.
"Some process may slow down the speed of execution in the short term, but we do not see a longer-term impact." he said.
Mr. Woodward added: "A dealer taking on risk may be deterred as they will know that the price a trade was executed at will be reported to the wider market. This could impact liquidity."
Mr Woodward said that was seen in the U.S. with the introduction of the Trade Reporting and Compliance Engine, which facilitates the mandatory reporting of over-the-counter secondary market transactions in certain fixed-income securities.