Recently, the European Commission commenced its overhaul of securities markets regulation with the publication of the eagerly-awaited revised Markets in Financial Instruments Directive, dubbed “MiFID 2”. Nearly a year in the making, the legislative package puts transparency at the forefront with ambitious proposals to shed light on trading in practically all financial instruments — from equities to bonds, derivatives, and even emissions trading allowances.
CFA Institute has contributed to the transparency debate with the publication of a recent report, An Examination of Transparency in European Bond Markets. The report, authored by Heidi Learner, CFA, examines the existing state of transparency in bond markets, drawing from the experiences of Italy and the United States — the two main markets that already require the publication of transaction details, such as price, time, and an indication of size, for certain fixed income securities.
In evaluating the merits of greater transparency, the report compares the structure of the bond market to the equity market — the only asset class for which transparency requirements were applied under the original MiFID. Unlike equity markets, dealers play a significant role in bond markets, maintaining an inventory to trade bilaterally with customers before adjusting their exposures in the inter-dealer market. The sheer number of debt securities, the large sizes in which they trade, and, away from government bonds, the relative infrequency of transactions and low secondary market liquidity are all conducive to an over-the-counter (OTC) market structure. But as a consequence, investors must rely on indicative quotes provided by dealers, which can often be wide of the mark of executable prices.
Improving Information for Investors and Protecting Dealers
On the basis of the findings of its report, CFA Institute believes that careful implementation of post-trade transparency requirements in European bond markets can benefit investors by improving access to pricing information, reducing the information asymmetry between investors and dealers, and increasing competition in the provision of pricing quotes. More specifically, we make the following four recommendations:
- Firstly, post-trade transparency requirements should be calibrated to take account of the size and liquidity of the issue. In other words, the information to be reported, and the timeliness with which that information is reported, should be a function of a bond’s liquidity characteristics. For example, it should be possible to delay the reporting of very large trades for an appropriate length of time to allow dealers to hedge their risks. Such calibration should address some fears that dealer positions would be needlessly exposed to the market from increased transparency.
- Secondly, new transparency requirements should be implemented gradually to allow market participants time to adjust trading processes and systems, and to avoid the risk of a temporary liquidity shock.
- Thirdly, authorities should develop standards over the content, format, and distribution of post-trade data. Investors need access to accurate and reliable information on bond transactions to facilitate the investment decision-making process. And consistent standards over trade reporting are necessary to facilitate the consolidation of post-trade data to provide investors with an aggregate view of bond market transactions.
- Fourthly, with regards to pre-trade transparency, it seems that a uniform standard on the publication of quotes prior to trades being executed would be impractical at this stage. More generally, increased market acceptance of electronic trading platforms that continue to grow in Europe may lessen the immediate need for regulatory attention to this area.
The European Commission’s publication of MiFID 2 marks the beginning of the legislative process as the text moves on to the European Parliament and Council for negotiation. While many revisions will doubtless be made, one thing is certain: transparency will stay at the forefront of the agenda.