How do wider spreads discourage firms from participating in the bond market?
The impact of wider spreads will affect both buy- and sell-side market participants. As discussed last week, a multitude of new regulations is set to transform the role of brokers, who offer bond executions on a ‘matched principal’ basis.
Under this model, brokers assume a bond exposure on behalf of their buy-side client then seek to match it against the liquidity they hold internally themselves.
The new rules – which include new capital charges for assets deemed risky under Basel III – make it more expensive for the sell-side to hold an inventory of fixed income assets, increasing the costs associated with this trading model.
Is added regulatory capital the only issue?
No. In Europe, transparency could also be an issue. MiFID II extends its reach to the fixed income market and will attempt to bring some visibility to trading activity on a pre- and post-trade basis.
Currently, there is no pre- or post-trade transparency in the European fixed income market.
The issue European regulators are facing is how to calibrate transparency obligations. Bond trades are characterised by small, retail-sized orders, or large institutional block trades. This makes trying to apply a common transparency framework difficult.
With the matched principal model, the risk the broker assumes by taking on a bond position may need to be unwound if an internal match is not found immediately.
If the trade needs to be reported immediately, the rest of the market becomes aware of a bond exposure that still might be open, increasing the risk of market impact for the broker holding the position.
Again, brokers are likely to try and mitigate the added market impact risk, if MiFID II’s transparency proposals are too onerous, by quoting their buy-side clients wider spreads. Worse still, liquidity providers may simply just exit the market.
How will MiFID II aim to calibrate transparency for bonds?
The Irish presidency of the Council of the European Union has laid out options during its ongoing discussions on MiFID II related to when trade reports for bond trades an be deferred, as well as a compromise on when the precise size of a bond trade qualifies for delayed reporting.
Both proposals took the nature of bond liquidity into account and were specifically included by the Council to protect the sovereign debt markets.
The aim is to establish something similar to the TRACE system operated by the Financial Industry Regulatory Authority in the US, which includes delayed reporting and volume omission capabilities for managing the market impact associated with large trades.