ESMA Sets MiFID II Rules: Complex Balance between Transparency and Liquidity

The European Securities and Markets Authority (ESMA) recently published its final report on technical standards for the revised Markets in Financial Instruments Directive and Regulation (“MiFID II”). The totality of the text, comprising some 1,500 pages, reflects the vast scope of the rules and the complexity of implementing an ambitious legislative package crafted in the aftermath of the financial crisis. As is so often the case, the devil is in the detail, but with much of the detail applying to previously unchartered market terrain, it remains to be seen what consequences these rules will have for financial markets.

Fixed income markets are a case in point. Bond trading is mostly conducted over the counter (OTC) and historically has relied upon banks acting as dealers, maintaining an inventory of bonds to trade bilaterally with investors. This market structure reflects the lack of a steady flow of multiple third-party buyers and sellers, so investors have come to rely on dealers for immediacy. But the market structure is also partly a function of the lack of information about prices and market conditions faced by investors — a key issue that MiFID II seeks to address via a pre- and post-trade transparency framework for all nonequity financial instruments, including bonds.

The asymmetry of information between investors and dealers in bond markets provides some protection to liquidity providers by shielding their positions from opportunistic traders. In other words, there is a trade-off between the transparency needs of investors and the provision of liquidity by banks and other market makers. Balancing these competing interests is a delicate and complex exercise, and gets to the crux of the challenge faced by ESMA.

Bond Markets: Defining a Liquid Market

To this end, the calibration of the MiFID II transparency framework begins with an assessment of whether a liquid market exists. ESMA defines a “liquid market” as a bond that has an average nominal value traded of at least EUR 100,000; has an average of two trades per day; and trades on at least 80% of the available trading days.

For bonds deemed to be “liquid,” pre-trade transparency requirements (i.e., the publication of bids and offers) apply to trading on an organised venue. There are waivers from these requirements for:

• Orders that are “large in scale” (LIS) compared with normal market size
• Orders held in an order management facility
• Actionable indications of interest (IOIs) in request for quote (RFQ) and voice trading systems that are above a “size specific to the instrument” (SSTI, a set of thresholds that is separately defined within the legislation)
• Bonds that do not meet the liquid market definition.

On the post-trade side, details of transactions (e.g., prices and sizes) in liquid bonds must be disclosed “as close to real time as possible.” In practical terms, this means that transactions must be published no later than 15 minutes after a trade has taken place in the first three years of implementation, reducing to five minutes thereafter. There are also provisions to defer the publication of transactions for:

• LIS trades (relating to trading on an organised venue)
• Trades above SSTI (relating to trading on RFQ and voice trading systems, or OTC)
• Bonds that do not meet the liquid market definition.

The SSTI thresholds are set at a certain percentile of the LIS thresholds and are therefore lower. Further, the respective LIS and SSTI thresholds are lower on the pre-trade side than on the post-trade side to account for the different market risks ex ante and ex post. In all cases, the deferral period for publication of transactions is two business days (T+2 basis). National regulators will be able to lengthen the deferral period under some circumstances, or require certain details (such as volume) to be masked upon publication.

As these details and exemptions underline, getting the transparency framework right is a balancing act. Clearly, the calibration hinges on the liquid market definition, and here there is another balance to be struck, that between operational simplicity and precision.

COFIA vs IBIA

In a previous iteration of this framework, ESMA grouped bonds into classes and specified liquidity according to issuance size — the so-called “Classes of Financial Instruments Approach” (COFIA). If a bond belonged to a specific class (e.g., sovereign bonds, senior nonfinancial corporate bonds, etc.) and was above the applicable issuance size for that class, then it was deemed to be liquid. However, back-testing of this framework found that COFIA resulted in a relatively high proportion of “false positives,” i.e. bonds that are classified as liquid under the framework but that are, in fact, illiquid.

CFA Institute noted in its response to ESMA during the MiFID II/MiFIR consultation phase that:

“The key issue is the number and proportion of bonds that are classified as liquid (being above the respective issuance size threshold) but that are, in fact, illiquid .… Incorrectly classifying illiquid bonds as liquid would discourage market making in these issues and further reduce turnover. In contrast, incorrectly classifying liquid bonds as illiquid (being below the respective issuance size threshold) is less of a concern for market participants because liquidity in these issues will be at least maintained.

Based on the data presented in [the Consultation], approximately half (and in some cases more than half) of the bonds above the issuance size threshold are actually below the liquidity thresholds. We suggest that ESMA devotes further analysis to the data … [and that] further work should be undertaken to examine this result and to refine the framework where possible.

It is also important to undertake regular reviews of the framework to ensure its continued appropriateness. Bond liquidity is also a function of time, with the vast majority of turnover taking place in the weeks and months after issuance. Over time, even bonds with high issuance could become illiquid, potentially increasing the classification error. To the extent possible, ESMA should review the framework frequently to ensure its accuracy and appropriateness.”

In the final rules, these two concerns have been largely addressed. ESMA has dropped COFIA in favour of an “Instrument by Instrument Approach” (IBIA) for the liquidity classification, and has built in a quarter-on-quarter reassessment to account for the time decay of bond liquidity. Whilst more operationally complex, the revised framework is certainly more precise.

Under IBIA, the liquidity of each individual bond is assessed against the aforementioned liquid market definition, which then determines the applicability of pre-trade and post-trade transparency rules. New issuances are deemed liquid if the issuance size is above a given threshold (which is separately defined).

Thereafter, the liquidity assessment is conducted each quarter and is based on data for the preceding calendar quarter. Bonds are reclassified as liquid or illiquid according to the most recent quarterly data.

According to the data provided by ESMA in Annex II of its final report, this dynamic approach increases the accuracy of the framework: More than 80% of liquid bonds are correctly classified in each quarter, a significant improvement on the previous iteration (where the corresponding proportion of false positives was closer to 50%). Moreover, because the framework is dynamic, the proportion of liquid bonds correctly classified stays stable over time. This is because bonds that became illiquid during one of the quarterly review periods drop out in the subsequent quarterly assessment, thereby not impacting the classification error.

On the other side, more than 98% of illiquid bonds are correctly classified in each quarter. (We would expect this proportion to be higher since illiquid bonds typically stay illiquid.)

Overall, ESMA’s analysis shows that under the IBIA framework, less than 3,000 bonds are classified as liquid and therefore subject to transparency rules, whilst more than 70,000 bonds are classified as illiquid and thus exempt. Whilst only a fraction of bonds will be covered by the transparency rules, it should be recognised that bond trading is concentrated in the most liquid issues. To realize MiFID II’s aim of increased market transparency, it must be hoped that in terms of value traded, the majority of bond turnover will be encompassed.

Ultimately, until the framework is put into operation, it will be difficult to judge whether ESMA has found the sweet spot. Starting off with a more conservative calibration, with scope to adjust in subsequent time periods, seems like a sensible approach and should allow market participants (and market liquidity) to adjust to the new regime.

The European Commission now has three months to approve ESMA’s technical standards (which also cover revisions to equity market transparency rules and new rules on algorithmic and high-frequency trading, which we will cover in a separate blog post).

Also not mentioned here are the so-called “delegated acts” which cover, among other things, inducements rules and proposals to unbundle payment for investment research from trade execution, a topic of political contention. The delegated acts are expected to be published by the European Commission in November.

It is clear that the MIFID II saga is not yet over.

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