The framing of pre-trade transparency obligations under MiFID II and the burden placed on systematic internalisers (SI) could undermine liquidity provisions for swaps in Europe, according to lobby group the International Swaps and Derivatives Association (ISDA).
MiFID II’s accompanying regulation introduces an obligation to trade clearing-eligible and “sufficiently liquid” derivatives contracts on exchanges, multilateral trading facilities (MTFs), or the newly-created category of organised trading facilities.
But in a policy recommendation published this week, ISDA revealed concerns that the regulation’s pre-trade transparency requirements of continuous quoting and public prices in these venues pre-supposed trading in a central limit order book environment, and that such a presupposition was appropriate only for deeply liquid markets with many participants and simultaneously available matching trading interests.
ISDA worried that any potential move from quote-driven markets – which currently characterises the vast majority of OTC derivatives – to order-driven markets – like those of exchanges and MTFs – was only likely when flow had reached a level at which the customers were willing to accept execution risk.
“Seeking to impose such a model of transparency on the non-continuous trading that characterises large segments of the OTC derivatives markets could undermine liquidity in the market by potentially revealing participants’ trading interests, encouraging others to trade against them,” ISDA said. “This could lead to a widening of spreads [and] poorer pricing for clients. This is particularly problematic in OTC derivatives markets, where dealers tend to hedge the risk associated with a trade with a client over an extended period of time.”
ISDA has raised similar liquidity concerns in the US, where the country’s the Dodd-Frank Wall Street Reform and Consumer Protection Act will require swaps to be traded on newly created swap execution facilities (SEFs). There, ISDA is pushing that only those instruments which are fully fungible be made available to trade on SEFs.
The lobby group has also taken issue with Europe’s rules for systematic internalisers trading clearing eligible OTC derivatives.
SIs are defined as venues, operated by investment companies, that deal on their own account on an organised, frequent and systemic basis. These types of venues would be required to provide firm quotes when prompted for a quote and when the company agrees to quote. SIs would have to make all firm quotes available to all clients, and to the public for orders below a certain size. The venue would also be forced to enter into transactions with any other client to whom the quote is made available below a certain size.
ISDA believes such conditions could have the potential to decrease the attractiveness of providing market liquidity in many instruments.
“If firms were compelled to quote the same price to all clients, they would quote based on the profile of the most risky client and the risk of being asked to enter into numerous transactions,” ISDA said. “[SIs] would be forced to implement defensive pricing strategies to protect themselves, resulting in widening of spreads and poorer execution for clients.”
Instead, ISDA argued effective price formation could be better supported through targeted measures, such as a requirement that firms establish quoting policies.
MiFID II is currently under review by the European Parliament. Once parliament agrees its amendments, the Council of the European Union will conduct its own examination of the laws. The implementation of legislation is expected in 2014.