The clue is in the name

Much of the talk surrounding Europe’s planned organised trading facility (OTF) regime is centred on the future of equity broker crossing networks. But the implications for firms that facilitate bond trades should be more of a concern to the market.

The debate revolves around the use of the term ‘matched principal’ for non-equity trades and whether it could be misconstrued by banks and interdealer brokers to include some forms of ‘proprietary trading’.

At present, the bond market in Europe is largely driven by the role of the sell-side as liquidity providers, offering liquidity on a matched principal basis. In equities, risk trades are conducted on this basis too, but make up a small proportion of overall trading. As part of efforts to improve transparency in the fixed income market this type of trading will be conducted through the OTF under MiFID II.

The Council of the European Union appears to be contemplating whether or not to include matched principal as part of the OTF rules, despite the fact it was included in the European Parliament’s final version of MiFID II and the European Commission’s initial draft.

The European government’s concerns appear to stem from the fear that banks will use the definition of matched principal to incorporate some forms of prop trading in their OTFs.

To work orders on a matched principal basis, an intermediary stands between two counterparties trading a bond in order to match orders by simultaneously arranging offsetting trades using their own capital. Prop trading is generally defined as the use of bank’s own capital to trade for its own profit.

While it’s true banks’ ability to act as liquidity providers for bonds will diminish as Basel III rules make it more expensive to hold such assets on their balance sheet, denying them the opportunity to use the matched principal model goes against the way this market has historically operated. Prevent matched principal trading risks a further drain on liquidity by hitting interdealer brokers at the same time.

“Interdealer brokers provide a vital function in preserving the liquidity of and maximising participation in both the corporate and government debt markets,” asserted Alex McDonald, CEO, Wholesale Markets Brokers’ Association at a roundtable last week. “To continue offering this role, proven methods of trade execution, such as matched principal, should be embraced. Mandating changes to established forms of market practice, without fully appreciating the value of the service that interdealer brokers provide, is likely to seriously affect the functioning of secondary market liquidity, most particularly in light of the increased demands upon collateral fluidity arising from several new legislations.”

A double regulatory blow that hits the two types of market participant that are vital to facilitating trading in this asset class could do a lot of damage to the liquidity available for institutional investors.