25 February 2014

ESMA/Ross: Liquidity and new financial market regulation

Five years ago the regulatory community around the world was preparing what would later become the G20 leaders’ statement following the Pittsburgh Summit. It was the start of a regulatory and legislative overhaul and, one of the biggest globally coordinated financial sector reform ever... Today the results of the new legislation are becoming more and more tangible for financial markets. In that respect, 2014 will become a crucial year, especially for anything to do with financial markets infrastructures. 

Liquidity and MiFID II

For those areas where ESMA is required to develop technical standards, we intend to first publish a discussion paper and hold a public hearing on the key strategic elements before beginning the more detailed drafting. This process should allow sufficient input to develop the draft technical standards – on which we will consult the public again later in the year/early next year (through a “consultation paper”).

Since 2007, MiFID has undoubtedly increased business opportunities through competition and enhanced investor protection within the EU. MiFID II will continue along that path. Especially as there is a clear political willingness and agreement – and this is also reflected in the legal act – to increase transparency for example by including more financial instruments, ranging from equity - like to non-equity financial instruments, within the scope of MiFID. Market practices, and possibly market structures, will change as a result of this. I know that some of you are concerned about this but things cannot stay as they are today. ESMA will monitor the market evolution to ensure that the thresholds remain adequate or if changes in market conditions require different parameters.

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We are... aware of the significant impact that our future regulatory work under MiFID II may have on liquidity within EU financial markets… Over the last months we have seen signals for improved liquidity as well as the persistence of previous tensions in bond markets:

1. After a substantial fall in the third quarter of 2013, bond volatility continued to decrease at the beginning of the last quarter of 2013. Volatility for short term bonds however increased sharply as of October 2013, whereas it remained stable for longer maturities;

2. Despite a slight decrease in bid-ask spread of euro area sovereign bonds with 10 year maturity between the fourth and third quarter, liquidity conditions remaining different across Member States; and

3. Finally, issuance of sovereign bonds in the second half of 2013 was lower than the issuance in the first half year, reaching its lowest level since 2008, down 32 per cent from €630 billion in the first half year of 2013 to €429 billion.

From this evidence, it is clear that liquidity in the bond market is still fragile and that ESMA’s regulatory framework may have a critical role in order to safeguard the functioning of this market and its liquidity…

Protecting the liquidity of the bond market is of paramount importance. However, even if the concept of liquidity in the equity market cannot be mechanistically extended to the bond market, this does not necessarily imply that transparency rules should be more lenient for bonds or derivatives with respect to equity in all cases. As I said earlier, the right calibration of the thresholds, which will be based on different parameters with respect to those provided for the equity market, will ensure that the ability of trading firms to provide liquidity will not be undermined and that the impact on trading costs for investors will not limit the ability of governments and companies to raise capital.

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Other aspects of MiFID II implementation

MiFID II is about more than defining liquidity. With regards to micro-structural issues, topics such as mechanisms to manage volatility, where ESMA has to deliver a new set of guidelines, market making schemes and strategies, fee structures, tick sizes and maximum order to trade ratios will also have a significant impact on the market.

ESMA’s work will also embrace brand-new topics such as mandatory position limits and position reporting for commodity derivatives, reasonable commercial basis and non-discriminatory access to trading venues and CCPs, highly controversial areas that have not been at the core of the activity of financial regulators in the EU in the past…

I believe that it is fair to say that MiFID II will determine a more prominent operational role for ESMA in the upcoming years. Although I know that equities markets are probably not at the top of priorities for this audience, a clear example of this is the double volume cap mechanism aiming at limiting trading under the reference price and negotiated trade waivers foreseen in MiFIR. In this context, ESMA will be required to calculate the amount of trading carried out both under the waivers and as a whole on each trading venue and per financial instrument, in order to check if the trading activity under the waivers on a trading venue approaches or exceeds certain thresholds...

The work for ESMA does not end with the delivery of technical standards and advice for which it is mandated. Similarly, for MiFID II, the next step for ESMA after the rule-making will be the implementation phase of the new regulatory framework. Among the different tasks, the trading obligation, to determine which derivatives should be traded on venues, is one of the most important ones that ESMA will have to tackle.

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ESMA sent, on 14 February 2014, a request to the European Commission to clarify the scope of MiFID and EMIR when it comes to certain derivatives... ESMA noted the lack of clarity of the definition of foreign exchange forwards and physically settled commodity forwards when it comes to their inclusion in the MiFID list of financial instruments for the purposes of applying the EMIR provisions. MiFID was developed before the start of the crisis to which EMIR is a response. It is not surprising that the goal and purpose of MiFID in relation to FX derivatives was different from EMIR’s objectives and that more clarity is needed of what is the exact frontier between spot and forward markets and on how to treat FX derivative transactions used for commercial purposes. Whilst waiting for the European Commission’s clarification ESMA has proposed not to apply the EMIR provisions to those contracts where there might be differences in terms of their classification as derivatives across Member States.

To conclude, I would say that the EU is on its way to fulfilling the G20 commitments and is progressing well towards more transparent and fairer financial markets, but there is a lot still to come.

Full speech

Rick Watson, AFME's head of capital markets, said Ross' speech made it clear ESMA recognises the important differences between equity and bond markets and that it plans to calibrate liquidity based on fixed income specific data. ESMA also recognised that fixed income markets will "require a flexible and dynamic approach to calibration and waivers thresholds", Watson said. The watchdog will monitor the liquidity of bonds regularly once the new rules are in force, meaning that if a bond becomes less liquid over time as many do, they could be exempt later on from the toughest transparency rules.

Further reporting © Reuters

© ESMA