Industry bodies are split over how best to class non-equity instruments under MiFID II in order to determine whether they should be subject to transparency rules.
The European Securities and Markets Authority (ESMA) proposed two approaches in its May discussion paper on the implementation of regulatory technical standards for MiFID II.
The instrument-by-instrument approach (IBIA) would determine whether a non-equity instrument is liquid enough to be subject to pre-trade transparency rules based on its individual characteristics. But ESMA favours the classes of financial instruments approach (COFIA), which would identify instruments as belonging to a certain class, such as grouping bonds into sovereign, corporate, covered and so on.
However, industry responses to the discussion paper, submitted at the beginning of August, reveal a split not only on which approach should be adopted but how COFIA should be implemented.
Supporters of the COFIA approach include the International Swaps and Derivatives Association (ISDA). However, in contrast to the broad categorisation suggested by ESMA, ISDA believes a far more granular approach is required to ensure classes of instruments are sufficiently homogenous.
“ESMA must consider the granularity of classification and the thresholds themselves as intimately linked – the more granular the approach, the greater the likelihood that the thresholds will be set at an appropriate level,” it said in its response.
Fixed income electronic trading platform provider MarketAxess has also given its support to COFIA.
"The way instruments are defined as being liquid or not is going to be central to getting non-equity markets right in MiFID II. We believe this should be done based on groups of instruments as the individual instrument approach has some major drawbacks," Jim Rucker, global head of operations services at MarketAxess, said.
"Having to look up liquidity definitions for individual instruments would be a huge administrative burden that would be challenging to measure and track. For example, you will find individual instruments will move in and out of the liquid market definition at different times, meaning reporting will be incomplete and it is difficult to look at their activity levels over an extended period."
However, other firms and industry bodies have argued that, despite the additional overheads associated with an IBIA approach, it will be the only way to ensure trading is not adversely affected by the new transparency rules should they end up being implemented on highly illiquid instruments.
Alex McDonald, chief executive of the Wholesale Markets and Brokers Association (WMBA), believes many of the suggestions for COIFA are so complex as to be little use.
"The proposed COFIA approach is far too complicated, with 500 classes that bundle lots of things together that can have very different liquidity profiles. Additionally, moving instruments between classes potentially creates a risk of stopping trading in that instrument, a major downside. For this reason, we are backing the single instrument approach," he explained.
Asset manager BlackRock also believes that the divergent liquidity profiles of instruments within each of the classes proposed by ESMA means IBIA is the only way to ensure instruments are judged fairly.
It added: “At this point, we do not believe that sufficient evidence is available to demonstrate that it is appropriate for COFIA to be used for any particular class of instrument, without the potential to negatively impact liquidity. However, it may be appropriate for ESMA to revisit this point in due course, once accurate and complete data is available to reach the conclusion that COIFA is appropriate for some classes of non-equity instruments.”
ESMA’s consultation process has now closed and the pan-European regulator is currently considering over 350 responses to more than 500 questions in order to prepare draft regulatory technical standards by the end of the year.