For Whom the Bell Tolls
– Will MiFID II Bring About the End of the OTC Era?
MiFID II/MiFIR is a broad regulatory complex, that influences a lot of activities within the banks. Currently, people within the financial sector across Europe are busy getting it right and delivered in time. In three editions, I can hopefully broaden the perspective of the consequences of MiFID within the next couple of years. In this series of posts, I will take my point of departure in three important markets: equity, bonds and derivatives.
In the first post, we looked at the likely development of trading patterns in the Danish equity market.
And so, let’s turn to bonds.
By Christian Thygesen, Managing Partner | 3rd October 2017
The Danish Bond Market
Again, the Danish market is a bit different from other European bond markets in two ways relevant for the discussion of the effects of MiFID II:
- For one, bonds were included in the Danish implementation of MiFID back in 2007.
- For another, the Danish bond market is huge, at almost twice the size of GDP, driven by Danish mortgage bonds, which have a nominal outstanding value five times the size of Danish public debt.
In absolute terms, the Danish bond market is reasonably big. In relative terms, it is the world’s largest by a healthy margin. And so, what happens to the Danish bond market matters to the Danish Financial sector.
As mentioned, bonds were already included in MiFID in 2007, and so there is already a post-trade transparency obligation for OTC trades in Danish bonds.
This only goes for trades involving Danish institutions, but still covers a significant share of trades, at least when you do not consider large volume trades, which benefit from the large size transparency waivers.
The Transparency Obligation
Given the size of the bond market, and particularly the large amount of illiquid series of mortgage bonds, the transparency obligation is regarded as a benefit for the whole sector, as even the large institutions struggle to price the large illiquid segments of the market.
So, from this point of view, continued transparency is of benefit to all.
On the other hand, market makers have argued, that in a market with decreased liquidity forcing market makers to “show their hand” though increasing or even maintaining transparency obligations would make them less likely to take on the large positions, that are vital to the bond market’s central role as liquidity buffer for the asset managers, further decreasing liquidity and making a bad situation worse
(Decreasing liquidity has been the topic of numerous articles and seminars and seems to stem from a variety of factors preceding MiFIR, among them lower income through the historically low interest rates and higher costs of holding fixed income due to CRD IV).
Transparency Rules Under MiFIR
Whereas MiFIR will significantly increase transparency in the bond markets across Europe, in Denmark, the new transparency rules under MiFIR (where bonds in this respect are pooled with derivatives) are less stringent than the existing ones (where bonds follow transparency rules close to those for equity).
So, from that perspective, price transparency might have decreased in the Danish bond market under the new rules.
Keeping this in mind, the Danish FSA pulled a stunt by granting reasonably widespread transparency waivers, on the paramount condition that market participants agreed to respect the existing market practice on transparency in key areas through a formal sector-wide agreement still under development.
Another key decision by the FSA was to except all trades directly relating to house financing from MiFID.
The SSTI – Size Specific to the Instrument
One consequence of that is, that the so-called SSTI (Size Specific to the Instrument – the value of trades up to which the SIs must display actionable prices) will be significantly larger for bonds (maybe up to € 1.5 million) than for equity (€ 10,000).
Market Risk of Being SI in Bonds
The market risk associated with being an SI in bonds is thus significantly larger than for being it in equity, and this is underpinned by the fact that for equity, you become SI ISIN by ISIN, whereas for bonds, you become SI for all ISINs of an issuer in a given asset sub-class once you passed the SI thresholds for a single ISIN in that sub-class of that issuer.
Given the size of the market carried by only a handful of issuers, you will fall hard if you involuntarily trip over the SI-thresholds for any Danish mortgage bond.
It would seem this mechanism – combined with the high SSTI value – has helped fuel the move of Danish medium sized banks, towards executing their trades on venue.
How dramatic this move will be, as well as what share will be traded by SIs relative to the exchanges and good old OTC, remain to be seen.
Increasing Overall Rate-Level for Danish Mortgage Bonds
I respect the genuinely held view by sell-side professionals, that the market may suffer real damage from increased transparency.
The scenario they see is an increasing overall rate-level for Danish mortgage bonds, as the market becomes less attractive for those investors that depend on the market’s ability to act as liquidity buffer, taking their money elsewhere and leaving the market for more “buy-and-hold” investors.
However, on balance my guess is that those that predict that the bond markets are inherently different from the equity markets and will never be price-driven, might find themselves on the wrong side of the historic fence built by MiFIR
– if not for any other reason, then because that is the clear objective of the fence-builders.
Christian Thygesen, managing partner
Christian Thygesen has been employed in the financial sector since joining the Danish Central Bank in 1992. From 1998 to 2002 he worked for the European Central Bank in Frankfurt, dealing first with financial infrastructure monitoring and then monetary policy in the office of capital markets and financial infrastructure. From 2002 to 2007 he was Head of Projects & Analysis at Roskilde Bank.
Since then he has worked as a consultant in the capital markets area with focus on efficient implementation of regulation and system selection in its many guises.
You can read more about Christian and our other CMP consultants here.