MiFID II and Fixed-Income Price Transparency:
Panacea or Problem?
In light of the ongoing review of the Markets in Financial Instruments Directive (MiFID II), this latest research from TABB Group investigates the potential impact of the review’s pre-trade transparency proposals on the fixed-income market, its participants and the real economy.
With a decline in risk appetite and concerns over impending regulation, the fixed income industry is struggling under the weight of the current economic climate; investors are frustrated at their inability to find liquidity, companies are frozen out of the debt markets, and sovereign issuers are progressively becoming reliant on domestic investors as international financiers retreat.
Under the MiFID II current proposals, the regulators’ objectives are to encourage all organised trading on to regulated trading venues, similar to equities, and mandate a consistent level of pre- and post-trade transparency for all clients.
While equity can successfully be traded on exchange, more fixed-income instruments currently trade over-the-counter (OTC). A company may issue only one or two classes of equity, but will issue debt spread across a range of products, most or all of which are rarely likely to trade, making it challenging to find continuous liquidity.
TABB’s research finds that MiFID II’s proposal for pre-trade price transparency will harm current fixed-income market efficiency and liquidity. The existing market making model is already under stress due to the current economic conditions. If market makers are forced to increase their transaction costs, restrict their client base or pull away from the market entirely in an attempt to avoid risk, this will have a negative impact on trading activity and overall market liquidity.
While liquid debt is likely to continue to trade efficiently, less-liquid issuances that stray away from more standard offerings will become increasingly harder to sell. Market makers will be forced to price adversely, as they will have to drop to a price where a buyer is enticed, making it more expensive to trade and provide the necessary capital requirement to cover exposures. This adverse pricing will create a negative loop of decreasing trading activity and subsequent market liquidity, which will lead to increased market volatility.
For investors mandated to hold bonds as part of their investment strategy, the tendency will be to invest predominantly in only sufficiently liquid bonds, to minimise market impact and trading costs. Many investment mandates are already restricted to a limited universe of the strongest sovereigns and the largest corporates. The adverse market activity will reduce the ability of investment managers to diversify their portfolios, impede the ability of SME’s to access financing and hinder some governments’ ability to finance their debt; to the detriment of the wider economy as a whole.
Fixed income markets will become more automated and there are a limited number of products which could possibly be traded on an equities style exchange model. An appropriate level of transparency is beneficial. However, forcing full transparency irrespective of the asset class traded, the order type or the market conditions, is likely to come at a cost. The maintenance of all market-making operations will remain essential for the orderly functioning of fixed-income markets going forward.
The TABB Group study, MiFID II Regulation: Panacea or a Problem?, examines the current structure of the debt markets and the increasingly important role they play in the wider economy. The study explains why debt markets are distinct and cannot be viewed in the same light as equity markets, and why they require different investment, distribution and trading structures. We then investigate the various types of debt trading structures, the notion that fixed-income markets are primarily institutional, the role of primary versus secondary market activity, and how the secondary market operates in relation to indicative pricing, firm quotes and actionable orders. The final section of the study looks at the regulatory changes proposed in MiFID II and the effects they will have on pricing, disclosure, order execution and the ability to raise capital.