Fixed income traders are warning pre-trade transparency rules under MiFID II will undermine already diminishing liquidity, as no realistic solution to the problem currently exists.
An investigation by The Trade found traders are regularly being forced to ‘show their hand’ when using trading platforms to trade bonds, as screen prices are often not executable.
Mark Winter, head of dealing at Santander Asset Management was among the many buy-siders to speak to The Trade.
He said the firm’s fixed income trading desk has experienced this, noting it to be “a worrying trend”.
He said: “It’s a worrying trend. It’s less than helpful to the buy-side when you show your hand and do so gaining no benefit. Signalling and leakage will negatively impact your ability to find liquidity later down the line.”
If regulators do not step in, the buy-side has warned it means end investors could lose out as price manipulation and information leakage could increase under the new rules.
Jean Sayegh, senior portfolio manager at Lyxor Asset Management, explained: “As soon as you need to communicate with the outside world about future trades, you will face an issue of price manipulation and decreasing liquidity.”
Many buy-side dealers are scared to speak out publically because they are frightened that it may be seen as a slight by the regulator.
One fixed income dealer – who asked to remain anonymous – explained pre-trade transparency rules simply wont work in fixed income markets.
He said: “The market is worried about an increase in price manipulation and information leakage following the implementation of pre-trade transparency rules. Those are the issues we face in a pre-trade transparent world.”
Price manipulation has been raised as a serious issue, with trades often rejected and figures shown on screens not representative of executable prices.
However, representatives of the platforms that advertise these prices maintain that the bid and offer quotes on the screen are purely to attract interest.
Jonathan Gray, head of fixed income EMEA at Liquidnet, said: “The ALLQ model is an example of where banks or liquidity providers advertise their prices.
“The bid and offer quotes… give the impression to the buy-side that there is liquidity. When you ask for a firm bid or offer however, they are often reluctant to provide one.”
A European-wide push for the electronification of fixed income transactions under MiFID II has been set out by the European Securities and Markets Authority (ESMA) with implementation beginning from 3 January 2018.
But many say that these expectations are unrealistic.
Trading consultancy Bridport & Co often handles queries from clients who are facing this particular issue.
Managing partner Jason Bell, said he often tells his clients that screen prices cannot be relied upon.
He explained: “Many market makers are acting increasingly like brokers themselves and working orders. It has become ever more important to know and understand how the street works and protecting client orders is a serious issue.
“If it becomes common knowledge a large order is being worked then it is highly probably that any bids received will be cancelled and nobody will bid for the paper.”
Given the widespread discussion on the topic, buy-side trade bodies have been keen to take action.
Arjun Singh-Muchelle, senior adviser on capital markets at the Investment Association said the organisation has reservations about some of the proposed rules under MiFID II for fixed income trading.
He said: “We were told that one of the reasons the instrument-by-instrument approach was chosen for the fixed income market was because it works for equities.
“As part of our role, we have actively represented our members views around the appropriate liquidity calibration method for the purposes of pre-trade transparency ahead of the rules being set.”
The Association for Financial Markets in Europe (AFME) agreed that the MiFID II rules could “further damage liquidity”.
Victoria Webster, director of fixed income at AFME said: “We see the appropriate calibration of the MiFIR pre-trade transparency regime for bonds as particularly critical because of the generally illiquid nature of that market and the consequent risks of potentially exposing liquidity providers.
“This, along with the best execution reporting regime - which does not distinguish between unexecuted RFQs and actual trades - also has a potential risk of exposing sensitive risk positions to the public, which could further damage liquidity.”
Liquidnet’s Jonathan Gray said regulators have taken the wrong approach to fixed income rules so far.
He said: “The FCA could think it works like equities – if there’s a price on the screen then that’s a firm price, but it doesn’t work like that in fixed income.
“When you send a request for liquidity you are showing your hand, and it’s information leakage. You’ve given something up for potentially no reward or gain, and the market impact of that could go against you.”
The Trade contacted the FCA who declined to comment.
Lyxor Asset Management’s Jean Sayegh said he thought that regulators had been guilty of “taking an equities approach to the fixed income rules.”
He said: “We are obliged to seek additional tools to completely comply with the new regulation.”
At The Trade’s specialist MiFID II event in Stockholm, Elina Yrgard, senior legal counsel for European affairs at Nasdaq, detailed the discussions she has held with ESMA on MiFID II. She said that the main issue is around how liquidity is calculated.
She said: “The European Commission wanted less transparency, but ESMA wanted to increase it. ESMA’s new draft says the rules are to be phased-in. It is about calculating which instruments are suitable for transparency and when the rules should apply.”
Yrgard’s view is shared by many, highlighting the importance of the issue.
Santander Asset Management’s Mark Winter said regulators must “rethink the text of these rules.”
He concluded: “It will not work the same way for equities and it could be a naive attempt to impose a ‘one size fits all’ logic. The buy-side is trying to be more vocal about this and raise the profile of this issue.”
The Investment Association’s Singh-Muchelle said that the proportion of corporate and sovereign bonds that will be determined liquid under MiFID II and will be made pre-trade transparent is a cause for concern.
He said: “The bigger issue is the fact that, following the proposed phase-in, around 90% of traded volume for sovereigns and 25% of corporates will be subject to pre-trade transparency.
“The system being implemented under MiFID II is more ambitious than other jurisdictions, and it’s likely to have unintended consequences.”
It is understood numerous trade bodies have raised the issues of fixed income rules under MiFID II to several regulators, but with no indication that those regulators are thinking of changing course.
Many say the rules have now been ‘set in stone’ and a further delay to implementation is highly unlikely.
Nasdaq’s Yrgard explained the rules are likely to go ahead as planned and will only be considered again by ESMA under MiFID III.
She said: “It’s very unlikely to be further delayed. Once the rules surfaced there was interest in delaying it, but many questioned whether this would ruin the progress so far and politicians would have to start over. But even those people agreed something needs to be finalised and put in place.”