By Arjun Singh-Muchelle
Europe’s capital markets are undergoing a tsunami of revolutionary change brought about by the Markets in Financial Instruments Regulation/Directive II (MiFIR/D II). For the first time, asset classes beyond equities will be subject to sweeping changes brought about by this wide ranging piece of European regulation.
The greatest change will arguably be felt in cash bonds, with the application of pre-trade transparency. This shift is particularly significant as it will mean that Europe will become the first (and only) region in the world that will have pre-trade transparency in this market.
To be clear, we have never supported pre-trade transparency as we do not believe that it contains any useful information for the market and does not reflect market reality. As such, its introductioncould have a detrimental impact on the prices asset managers are able to achieve for their clients. We have always however, supported robust post-trade transparency at both, the micro- and macro-levels.
As MiFIR/D II makes clear, transparency will only apply to those bonds that have been determined to be ‘liquid’. As such, the crux of the matter before the European Securities and Markets Authority (ESMA) is – for all intents and purposes – what is a liquid bond?
To answer this rather esoteric question, ESMA devised an amalgam of two methods of assessing a bond’s liquidity for the purposes of pre-trade transparency – the class of financial instruments approach (COFIA) and the instrument by instrument approach (IBIA). ESMA has outlined that COFIA will apply to newly issued instruments,and IBIA will applyto outstanding or existing instruments.
The instrument based approach will use historical trading data to try and predict future trading activity (which is challenging and questionable in itself); whereas the class based approach simply uses the issuance size of a bond to determine whether that new issue is ‘liquid’ and therefore, subject to transparency. A corporate bond, for example, that is issued at or above €500 million will be determined to be liquid and therefore, made subject to pre- and post-trade transparency.
Whilst we strongly support the use of issuance sizes for new issues to deem liquidity, the concern is whether the sizes selected by ESMA will appropriately capture the ‘correct’ instruments as ‘liquid’ and therefore, made pre-trade transparent.
In a letter submitted by the Investment Association and co-signed by 20 asset managers to the European Commission and ESMA, we made it clear that as far as newly issued corporate bonds are concerned, ESMA had got it wrong.
In order to help shape the debate and assist European regulators and the Commission, we conducted analysis based on dataprovided by Trax (a subsidiary of MarketAxess) that showed the weakenesses in the current proposed methodology. We found that under ESMA’s current approach (coupled with the Commission’s revised proposals for a phased-in application of transparency) around 97% of the newly issued coporate bonds will be misclassified as ‘liquid’ from 1 January 2018 and therefore, should not by definition be subject to pre-trade transparency.
Whilst of course, the COFIA issuance size thresholds will only apply for up to 5 and a half months from the point of issuance, newly issued corporates actively trade during this immediate post-issuance period. The mis-classification therefore, will be concentrated at the point in time when corporate bonds are most commonly traded, which is a cause of concern for Europe’s asset managers.
Our view has always been that the easiest and cleanest way to fix this problem, is to increase the issuance size for corporate bonds at which they will be deemed liquid and subject to transparency from €500 million to €1 billion. Following months of negotiation with policy-makers and regulators, ESMA has agreed to increase the issuance thresholds to €1 billion up to 31 December 2019. Whilst this again, is not perfect, it is a better outcome for Europe’s corporate bond market as the rate of mis-classification falls dramatically to 10% of the total sample.
Despite any further changes to the definition of what is a liquid bond – the changes brought about by MiFIR/DII will have a dramatic impact on the future of this market. With pre-trade transparency, it is likely that we will see proprietary houses enter this market as they did in the equity market and we are also likely to see asset managers revise their trading strategies focussing on niche, bespoke trades or going big to use the transparency exemption provided for large in scale transactions.
For the remainder of the market however, platforms and venues are the big winners of the changes. We are likely to see more executions take place on-venue rather than the current practice in Europe of the majority of trades being executing over the counter. As agents on capital markets for our clients, we strive to maximise our return for clients. As such, with the introduction of transparency for Europe’s bond market, it is likely to have a large impact on the prices we as intermediaries are able to achieve for our clients.
So, what does the future hold for Europe’s corporate bond market? Whether it is the right or wrong is up for debate, but we are certainly seeing the fixed income structure moving towards an equity based model. The interesting thing is, this is not by market evolution, but by regulatory design.
Arjun Singh-Muchelle is senior adviser, capital markets at the Investment Association
