Memorandum - QED · 2015-12-02 · Not all markets are ready to be traded in a completely...

Memorandum

MiFID II – Pre- and post- trade transparency

Memorandum

26 June 2012, Brussels

Eddy Wymeersch Former Chair, CESR

The original intention of MiFID I was to put an end to the centralised market system. The concern at the time when MiFID I was debated was that the cost of execution was much higher than for instance in the US. Therefore, competition had to be introduced. At the time the markets were national so another intention was to in tegrate the European Markets. When MiFID I came into force it changed everything. It has h a d v e r y f u n d a m e n t a l consequences. Trading has become decentralised and it is very difficult to have a clear view of the market as a whole. This creates a certain number of issues. We have not only many trading venues but also many different trading techniques. We have also seen a considerable rise in OTC trading.

The level of competition between different markets has increased substantially. The question is whether this has benefitted the final investor and if i t has benefit ted the ins t i tu t iona l investor. The answer to that question is mixed, if not negative. There is a concern that the changes have not been as beneficial to the final investor as was expected.

With the decentralisation of the trading we see that regulating the markets and in particular getting information about what is going on has become extremely difficult. The data that we have is still not very clear and therefore more work has to be done looking at the post-trade and consolidated tape. Today we have nothing in this aspect. I t is therefore surprising that the proposal is so weak in this area, relying on the spontaneous market forces. We have not seen the final text yet, but as it looks right now, it is very vague.

Best execution was one of the cardinal notions in the MiFID I directive and rightly so. Looking at how it works in practice, there are however very few mechanisms that ensure best execution in terms of price.

Memorandum MiFID II – Pre- and post-trade transparency

We have diluted its meaning by including too many things that should not be taken into account. The only criteria we have which is credible is the price. We have no mechanisms to verify whether a transaction that is being executed on one trading platform gets a better price than it should have if it would have been executed on another trading platform.

Dark pool is an awful terminology. We are making the same mistake by calling same parts of the financial system shadow banking. We immediately put a negative label. If we look at dark pools however, they are not at all negative.

When the MiFID I proposal was put forward there was a lot of discussion around the Systematic Internalisers. Those have however not become a great success. With the MiFID II proposal the regime is being reinvented. _____________________________

Dr Kay Swinburne Member of the European Parliament Equities and non-equities are different. For equities there is a broad acceptance that the existing system for waivers is actually a sensible place to be and as long as trades do not have an impact on price discovery we need to make sure that large-in-size trades can have a suitable treatment. Ms Swinburne believes that the four waivers in MiFID I are actually workable. The original reasoning for having them still holds. Even though they are necessary, there are certain interpretations in certain member states that may be needed to come to one unified interpretation. The role of ESMA in writing technical standards will be a huge


help in making sure that this actually comes about this time. Hence, in Ms Swinburne’s view, we do not need to move too far from where we already are with those particular waivers. Most of the work probably needs to be done in the implementation phase. Ms Swinburne thinks the post-trade transparency in MiFID I has been a complete disaster for the e q u i t i e s m a r k e t s . T h e transparency requirements and concept has not been enough. There was an accepted norm that when we put MiFID I in place and the competition increased that the report ing mechanism would continue. Obviously, that has not been the case for equities. Reporting trades to a venue not specifying how or where they need to go and what the purpose of that is did not seem to have been enough. Certainly, the market has not come forward with a consolidated tape equivalent. Ms Swinburne is concerned that we need to find a solution here. The Commission has come forward with a competit ive situation where we have the competing APAs and we have

consolidated tape providers that on a competitive basis can put an offer out there. Ms Swinburne is prepared to see that this could work. Her preferred option would, nonetheless, be to go straight for a s i n g l e m a n d a t e d t a p e . Unfortunately there is not a majority for that in the European Parliament. In order to get this to work, the consolidated tape providers must be required to collect the data from all the APAs. Otherwise, if they were to select only a few of them there would not be a consolidated tape equivalent. Therefore, we have to make sure that we end up with a tape that is worthwhile, i.e. a source of data in standardised form that can be used. In particular, this tape should be able to be used by the buy-side to actually determine whether or not they are getting best execution


pre-trade transparency and then move up the curve regarding when the criteria, most notably sufficient liquidity, is met for these certain instruments. Ms Swinburne would like to see r e a l l y g o o d p o s t - t r a d e transparency. This could serve as a p r o x y f o r p r e - t r a d e transparency. We have lessons to be learnt from the equities space. We need standardised sets of data and we need to have a format by which everyone reports the data in a set way so that we can have it consolidated into a usable form in the non-equity s p a c e . We a l s o c a n u s e technology to our advantage. We know now the advances that have been made in the equity space and that they can be applied to the bond market. Ms Swinburne hopes we will see the emergence of a post-trade tape for the bond

from their brokers. Equities are the easy part because we already have a system in place, which is working properly, and we can see what needs to be fixed. In non-equities the dangerous thing is going to be to take the equities template and try to put it into the non-equities space. This is in particular true for the different bond markets, which are in a very sensitive place in Europe today. The last thing we should do is cause too much disruption to them. There will be a problem if we start from the premise that we should have everything included for pre-trade transparency and we then must find waivers that allow people not to have pre-trade transparency. At this point in time our bond markets are very different from the equity markets and pre-trade transparency can potentially be damaging to the market structure. We should i n s t e a d a l l o w a n a t u r a l progression of these markets, where we start from the issue that pre-trade transparency is not required but that we will have a list developed and we will have a set of bond markets and bond instruments for actually having


Jasper Jorritsma Policy Officer, Unit G3 – securities markets, DG MARKT, European Commission MiFID I came into force in 2007 but the text has been around for much longer and reflects Europe as it was in around 2000. The main objectives of MiFID II are therefore to update the existing framework and in doing so, take into account all technological and market structure developments that we have seen in the past few years. Another crucial element that we need to encompass is the G20 commitment to have all derivatives on central trading facilities and have them centrally cleared where appropriate by the end of this year. EMIR will be able to deliver on the central clearing

market fairly soon. The one thing that is fairly apparent is that there is very little post-trade information right now for anyone who wants to invest in the bond market. When the buy-side starts to see a certain level of transparency they will realise that they want more of it. Hence the market pressure will b e t h e re t o i m p ro v e t h e transparency in a fairly rapid way.

To conclude, equities and non-equities really are different and we need to think of them in a different way when it comes to pre- and post-trade transparency regimes. The pre-trade needs to be very different for non-equities. As to the post-trade, however, we need to learn the lesson from the equities space. We can deliver something that will help investors and thereby encourage more investments and capital flow into Europe rather than dissuade it. _____________________________


have to follow the same rules and the same pre- and post-trade transparency requirements will apply to a financial instrument regardless of where it takes place. A Systematic Internaliser (SI) on the other hand is not seen as a venue since it does not bring two parties together. It is simply a broker trading with its clients. Hence there are different rules for SIs.

Pre- and post-trade transparency together provides information to i n v e s t o r s a b o u t t r a d i n g opportunities and facilitates price fo rmat ion , enab les market monitoring and helps firms to provide best execution. The Commission's proposal extends the transparency rules to bond and derivatives, with extended coo rd i na t i on by ESMA o f assessing waivers. In general, the Commission is critical of waivers but are happy to discuss which ones should be retained and in which forms. The only waiver that everyone agrees is good to have is the large-in-scale waiver. The only crucial question here is what is large-in-scale and does large-in-scale mean that it is large compared to normal size of the market or does it mean large in

aspect, while the central trading is expected by summer of 2014. MiFID II and MiFIR together with the Market Abuse Regulation and the criminal sanctions represent a comprehensive package. It is the Commission's intention to bring all th is , inc lud ing the leve l 2 measures, into force on the same date. MiFID II aims at creating a framework that includes all trading in financial instruments, i.e. not just equities but also bonds and derivatives. In order to do so, the Organised Trading Facility (OTF) category has been introduced. Not all markets are ready to be traded in a completely non-discretionary way on Multilateral Trading Facilities (MTFs) as they exist today. OTFs are a new venue form of hybrid platforms, which allow for discretionary matching. All types of venues will, however,


the sense of reta i l versus wholesale? In the Commission’s view a large-in-size order is something that is large for the market as a whole. Hence, the Commission does not simply envisage the pre- and post-trade transparency rules as being good for retail investors, they consider that they are there for market as a who l e and shou ld benefi t everyone, not just small investors. Concerning non-equities, a lot of work will have to be carried out at level 2 in order to calibrate the requ i rements to i nd i v idua l markets , p resumab ly even individual instruments. Crucially, in the bond market not every country or company is going to be equally liquid. Trading is not going to happen in the same way, there will be differences in the liquidity, in the futures markets and for derivatives even more so. Some are going to be very highly s tanda rd i sed wh i l e o the rs essentially are going to be more b e s p o k e p ro d u c t s t r a d e d amongst more sophisticated investors. The ones which are going to get caught by the new rules need to be able to continue to be traded. The objective of introducing these requirements is

not a halt for trading but to ensure that trading can continue in a t ransparent way. S imi la r l y, following the calibration according to type or even indiv idual instrument, the waivers have to be calibrated appropriately to actually match the elements of the transparency requirements. The same goes for delayed disclosure, which is going to be especially important in the non-equity sphere, where we have to take into account what the appropriate time frames are for different markets. R e g a r d i n g p o s t - t r a d e transparency there was a general expectation when MiFID I came into force that the market was going to be able to deliver on a consolidated tape, which so far has not been the case. There are some people who say they actually do have a consolidated


tape to offer but it is extremely expensive. What we want is a consolidated tape that is usable and available to everyone and not just as a very costly bespoke product. In the Commission’s proposal the approach this time is not simply limited to waiting for the industry to deliver. There is, however, some logic behind going for the commercial solution, which is that the main obstacle to the industry coming up with a consolidated tape is data quality. Therefore, what the Commission hopes is that by increasing data quality and harmonising the way data is reported across Europe it will be more economical to aggregate all data and hence for the industry to come up with a commercial solution. If it fails to do so, the current proposal contains a very strong review c l a u s e , w h i c h a l l o w s t h e Commiss ion to mandate a consolidated tape. How we are going to have pre- and post-trade transparency is a question that is going to be dealt with mainly at level 2. What is very important, however, is that we ensure that the empowerments, which we put in place at level 1, actually contain all the relevant

criteria. Nevertheless it is going to be at level 2 that we will have to go through the market instrument b y i n s t r u m e n t t o e n s u r e transparency and that the market will continue to function at the same time. _____________________________


Niall Cameron Global Head of Credit Trading, HSBC Mr Cameron focused on non-equities. To start with, we are making a mistake defining it as non-equities since it lumps all securities that are not equities into one single category. Credit derivatives are not the same as commodities, which are not the same as government bonds and so forth. One of the key things is that we need to start to get some granularity. We must take into account that each of the markets

has many sub-sectors and that even the regulation between one part of the credit market and another or one jurisdiction and another is completely different. The bond market today is very important. In the US around 30 % of financing is done through the loan market and the rest is through bond and securities markets. In Europe the loan figure is 70 %. The bank’s balance sheets are not going up but down. There is a variety of reasons for this but in either case, this means less bank lending. Also, the spreads have been very low. Therefore, not only is the cost going to go up but the access is g o i n g t o g o d o w n . A s a consequence, the capital markets will be crucial going forward. The question is if the regulation will help that process or hinder it and what other ideas and regulations we can put in place to speed up that transfer from the loan market to the bond market. There is a recent S&P report, which came to the conclusion that European companies need to increase their bond issuance by 50 per cent in the next five years due to a 210 to 260 billion dollar

shortfall from bank lending that has been made up in the capital markets. Transparency is in general a good th ing. In the bond market however, too much transparency can be very damaging. What we should try to achieve is an optimal level of transparency rather than c o m p l e t e t r a n s p a r e n c y . Furthermore it is often better to focus on the quality of the data rather than the quantity of data. What we saw from MiFID I, was that over night it became almost imposs i b l e t o p rove bes t execution due to the fact that there was no common standard and no common delivery. We should therefore make sure that we do not repeat the same mistakes in the bond market.


There is a huge amount of pre-t r ade da ta ou t t he re . An institutional fund manager of medium size will receive between 20 .000 and 40 .000 p r i ce messages per day. There is an asymmetry in that the sell-side has no view of this; they push the data into their machines and the buy-side sees all the information. Who really sees those messages is something that is being discussed but at the time being this is not regulated. Post-trade is more difficult and the arguments go both ways. The positive arguments are that it gives transparency, it gives confidence, it’s fair and it brings more people into the market. Those are very valid arguments. The counter argument is that in very i l l iqu id markets pr ice information can mean that the

buy-side investor cannot get his trade done in a sensible format or even at all. In the bond market, liquidity means that either you get a price or you do not get a price. This situation is getting a lot worse and it is even hitting the government bond markets. So it is not that we do not need extra liquidity - we need every single bit of liquidity we can have in the credit markets because they need to grow to do the financing which is taken out of the loan markets. Calibration is absolutely key in all this. We need to walk into this in steps so that we do not do the same mistakes as we did with MiFID I. We should put some in and then have a look, examine it, and then put some more in. ESMA is going to have a crucial role in determining this calibration. Consolidated data is not an area in which to experiment. You can have a mandated vendor-provided tape where basically all the data goes into that player and all the data comes out of that player. That keeps the cost to the absolute minimum for the overall industry. This solution will have one data standard, minimal leakage and they can even have


some regulatory responsibility. Hence , f rom the marke t ’s perspective, this is the preferred choice. It will give the best quality of data and the lowest price. There are concerns that i t p o t e n t i a l l y c o u l d l e a d t o comp lacency and l ack o f innovation but a frequent tender process will keep the vendors on their toes. The second choice, which is workable but, in Mr Cameron’s opinion, not as optimal is where the data standards are set by ESMA and collectors of data can compete on price, i.e. you allow pure competition in that area but you do no t ge t t he da ta fragmentation. Mr Cameron is, however, worried about the third choice, which is letting the market dictate a solution and if it does not work the regulators will come back and change it. This is better than nothing but unfortunately what it means is that the market

will probably not come together with a solution and we then will have two wait another couple of years before we have a mandated solution. We have to start looking through an additional lens on all regulation. We have to look at various areas such as the overall health of the market, how deep is the market, how useful is the market for participants and we need to look at cost. Cost is under pressure everywhere in the entire industry because of the low growth rates. Consequently excess cost and unneeded cost has been heaped on an industry, which, at the moment, is under duress. This is necessarily not a good thing. We also need to look at the practicality of implementation. When you look at all the regulation coming from principally both sides of the Atlantic, we have an enormous amount to adhere to as an industry at the same time. A lot of those regulations are conflicting with each other despite the best efforts of everyone to try to get them to coordinate. I think the most important of all is what is the effect of these regulations in isolation and cumulatively on the


real economy and the growth agenda. Every proposal that has been considered to solve the financing issues in Europe will ultimately fail if there is no growth. Regulation needs to help the growth agenda on top of the other objectives it has been set out to achieve. _____________________________

Elizabeth Callaghan Regulatory Principal Advisor – Capital Markets, KPMG Ms Ca l l aghan focused on synergies between equities and fixed income electronic trading, w h e r e t h e y m a k e s e n s e . Electronic Trading in equities was originally the result of the need for transparency. That need has not changed, only the drivers. The drivers for transparency in the late 90s and early 2000s were a combination of buy-side desire for


more informed decisions and evidence-based execution as well a s m a j o r t e c h n o l o g y advancements such as Order Management Systems and FIX Protocol. Today, the drivers are r e g u l a t o r s d e m a n d i n g transparency as a result of the market crisis and what happened with the liquidity crunch in 2008 and 2009. Ms Ca l l aghan ’s theory on transparency is that we should look at what is helpful and what is harmful and to whom. We always seem to talk about transparency as it relates to the sell-side but we need to think about the effect of transparency on the buy-side. At present, most of our pensions are control led by pension fund managers who in turn choose large fund managers to manage their assets. An integral part of the fund managers’ performance is how well they execute in the market. As you know, the buy-side uses the sell-side to execute. Understanding the effect of transparency, either positive or negative, on Fund performance is key. We know the sell-side provide the buy-side with execution services. These can inc lude Broker

Crossing networks provide the buy-side with a choice of any variation between light and dark. It is all dependent on the order itself. Now, he fact that the sell-side uses words like dark is not very helpful. Dark sounds shady, as if someone is doing something that is not right. Dark should be replaced by anonymous. Clients do not know who the other side of t h e t r a d e i s a s t h e y a re anonymous. Anonymity prevents market impact and information leakage and that is the whole point of executing in a dark pool or any other dark mechanism. Algorithms in a way can do the same thing. They take large orders and break them up into slices, which helps with market impact. Again, assisting the buy-side by not having their trade impact market prices. Important to note, there are execution practices that work today and are currently making markets liquid. This is particularly evident when you see synergies between equit ies and fixed income. For example, there are similar (but definitely not exact) methods of sourcing liquidity. With equi t ies one can use IOIs (Indications of Interest) and Trade

Adverts for liquid fixed income instruments one can search for liquidity on Bloomberg (such as AllQ). There are similar services to be found on TradeWeb or Market Access. Choice is vital to the buy-side when sourcing liquidity. However, his does not mean that some additional controls would not be of benefit.

The biggest examples of when transparency can be harmful and when waivers are necessary in facing off against transparency is large in scale and illiquid orders. Illiquid orders are orders that are rarely traded or are instruments where there are very few market makers. If there are few market makers, In the case of a few market makers, they certainly will not make a price if they have to be transparent because the minute they do so it will damage their market making ability and adversely affect their client.


Again, it is important to focus on - what is helpful and what is harmful to the market. Post-trade and transaction reporting is extremely useful. However, must be done correctly. Trade reporting is very valuable for price formation. You can see what has just traded and get an idea of what the pr ice should be. Transaction Reporting allows the buy-side to quantitatively measure the performance of the sell-side as well as performance down to the individual dealer level on the buy-side. Transaction reporting or Transaction Cost Analysis has even moved into the pre-trade space as the buy-side is using this for cost expectation as part of their execution strategy. This information is needed in fixed income as only in equities is TCA being used in the pre-trade space. While both trade reporting and transaction reporting and

transaction cost analysis is beneficial we still need deferred publication where a trade is illiquid. In the case of illiquid bonds however, you could report to the regulator for trade reporting but not to the market. That way t h e r e g u l a t o r s h a v e t h e i n f o r m a t i o n f o r p o s i t i o n management and market abuse purposes but the price formation is not damaged.

When it comes to a consolidated tape we should follow what has been taken place in the US with Trace, but also look at the lessons learned. There should be only one venue for reporting post-trade data. If you have several you risk providing an opportunity for discrepancies.

Ms Callaghan suggested that we should create a liquidity profile forum consisting of the debt management office and the primary dealers. They are the ones handling bond auctions today so they are well positioned to come together to determine which bonds are liquid and which bonds are not. An example of product synergies between equities and fixed income could b e C o m m i s s i o n S h a r i n g Agreements for equities and


Spread Sharing Agreements for Fixed Income. The beneficial result would be the rise in execution only brokers or MTFs and the creation of research boutiques for fixed income, similar to equities. However, the overall reason is to unbundle research and execution. This is a main tenant of the buy-side. In summary, the main points to remember are 1. Capital ise d e fi n i t e l y o n p r e v i o u s transparency work done in equities electronic trading to assist in transforming the other asset classes, in particular fixed income. However, ONE SIZE DOES NOT FIT ALL... 2. Always keep foremost in your mind the effect of transparency on the buy-side. 3. To borrow from another profession... “Must consider p o s s i b l e h a r m t h a t a n y intervention can do” - Hippocratic oath. _____________________________

Professor Norman Schürhoff Ecole des HEC Université de Lausanne, Senior Chair, Swiss Finance Institute Professor Schürhoff highlighted t h a t p re - a n d p o s t - t r a d e transparency is a delicate issue in over-the-counter markets. Too much transparency may harm liquidity provision and risk-taking by broker-dealer banks and other intermediaries. Too little liquidity, on the other hand, may also harm i n v e s t o r s a s i t c r e a t e s opportunities for rent extraction. The question is what the optimal degree of transparency is, which is mainly an empirical question. By the very nature of non-transparent over-the-counter markets with bilateral trade, we


have little or no data. It is therefore difficult to even observe prices and transactions costs and other measures of market liquidity. A push by the industry for some controlled experiment would be beneficial.

In addition, the market and regulatory environment has been changing rapidly over the past decade, partly due to the financial crisis. As a result, financial intermediaries have dramatically reduced their risk-taking activity, which has, at least in the US, led to significant reductions in bond inventories and, thus, in liquidity provision. The industry should therefore be quick to adapt to this chang ing env i ronment and contemplate alternative forms of trading, such as more electronic request-for-quote systems and other innovations. The US is currently undergoing similar developments.

Since there is very little data on E u r o p e a n b o n d m a r k e t s , Professor Schürhoff presented some statistics and findings from US sources on patterns and measures for market quality in OTC markets. This is meant to i l lustrate how OTC markets currently function.

In the US, reta i l investors participate much more in the bond markets than they do here in Europe. This also means that trading sizes are much smaller. Wha t we f ound was t ha t transaction cost for investors were significant. The average cost for a small trade is around 2,5 per cent. For a large trade, which is the most common in Europe, the spread is much smaller. This is the opposite of what we see in equit ies markets where the transaction cost for large-in-size orders are more significant than for smaller trades. Part but not all of the transaction cost can be explained by the fixed cost of intermediation. The law of one price means that at a given point in time a security should trade at one single price. In markets where there is no transparency we see that this is


not the case. Different investors pay different price for the same security at the same point in time. In the US exper ience th is difference goes up to 5 per cent. This is a result of opacity, i.e. that you do not know what someone else is paying for the security. The US experiment also showed that transparency, on the margin, reduces trading cost. The authors of the study drew the conclusion that improving transparency seems to benefit investors by improving investors’ ability to negotiate better terms of trade once they have access to broader bond-pr ic ing data. Another possible explanation is that transparency reduces the search cost, i.e. investors do not have to spend as much time to find the best price, which reduces friction costs and makes the whole system more efficient. Looking at the network of dealers and how trades take place within this network you see that there is a core of only 20 to 30 dealers. Those dealers trade heavily among each other. Then you have a large group of dealers who rarely trade with each other. Only 1,5 per cent of all possible

combinations are actually traded. This structure with a core and a periphery is very similar to a social network. This suggests that those dealer markets are potentially systemically risky. In other words there can be illiquidity spillovers. Comparing transaction costs between the core and the periphery shows that central dealers who observe more of the trade flow can charge up to 80 per cent more. Hence everyone wants to be a central dealer but only a few can.


We should also look at the structure of the market. Studies shows that the trading cost is substantially lower for electronic auction markets than for voice markets.

T h e o p t i m a l d e g r e e o f t r a n s p a re n c y a n d m a r k e t structure is a trade-off between intermediaries’ ability for liquidity provision and investors’ access to information.

This could be assessed in controlled experiments. At the same time the new capital requirements, which makes it much harder for intermediaries to provide liquidity at low cost, may mean that this debate is already out-dated to some extent since we will move towards more electronic systems in the future anyway.

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