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Liquidity is not a binary concept – it is multi-dimensional and exists as a spectrum. We can’t for example directly compare the liquidity of a FTSE100 share with that of a mortgage-backed security or a commodity option. And we should not confuse genuine liquidity with the volume of trading turnover. There is also a danger, in already liquid markets, of quickly decreasing marginal benefits of additional liquidity. What we are after is transparent and resilient liquidity.
Liquidity can be encouraged by opening up competition in trading venues, mandating certain pre- and post-trade transparency data and issuer disclosures, permitting trading on own account, and promoting orderly trading. Speculators and market makers are key contributors to the liquidity of many markets by putting up their capital in seeking to arbitrage differences in risk or time preferences.
Regulatory measures impacting on liquidity
Some of the measures legislators and regulators have, or are proposing, to come up with that may impact on liquidity
The first is the proposed creation in the Market in Financial Instruments Regulation (MiFIR) of a new type of trading venue, the organised trading facility (or OTF). This is one avenue through which Europe would meet the G20 commitment to bring standardised and sufficiently liquid OTC derivatives contracts into a more structured trading space.
The OTF also brings with it pre- and post-trade transparency requirements and a proposal to ban OTF operators from using their own capital.
We believe the introduction of this new type of venue category is a necessary part of the revised regulatory structure, and we support extending the scope of regulation – such as organisational requirements and access obligations – to some of the trading that currently takes place outside organised trading venues. But, as regulators, we need to ask ourselves whether it is in the best interest of end users – such as investors and corporations – to go further and prohibit certain structures without considering explicitly the impact on liquidity. For example, the ban on OTF operators using their own capital, if adopted, has the risk of damaging liquidity in bond and derivative markets.
The potential conflicts of interest when a firm is both an operator and a participant of a trading platform can be addressed by requiring OTF operators to apply rigorous conflicts management processes, as is proposed for MTFs.
A second important issue in MiFIR we need to reflect on is whether firms deploying algorithmic trading should be subject to continuous market-making obligations. We recognise that this proposal is motivated by a rational concern that, in times of crisis, algorithmic systems are likely to withdraw liquidity from the market.
A third area of changes that may impact liquidity are the G20 obligations to centrally clear and trade on organised markets OTC derivatives that are sufficiently standardised and liquid. In Europe, ESMA is working on technical standards which will be used to determine which OTC products will be subject to the mandatory clearing obligation. Two consultation papers have been published so far, with final standards required by September and national implementation from January 2013. These standards will be based on: the level of standardisation; the volume of trading and liquidity; and, the availability of reliable pricing information for the product. The FSA and HM Treasury will be consulting on implementation, but firms shouldn’t wait for this before starting to prepare.
MiFIR, still under negotiation, sets out a procedure for the determination of whether a derivative should be subject to the trade obligation. Again a key criterion is being deemed ‘sufficiently liquid’.
We’ll have to wait and see what the precise impact on liquidity in instruments meeting the trading and clearing obligations will be. It could be that the increased costs for users of central clearing will result in reduced market liquidity in some instruments as users decrease their hedging activity, or it could be that as more and more contracts become standardised, liquidity will increase.
A fourth area of change, is that of the application of rules across jurisdictions where it is important we do not segment and splinter hitherto more integrated markets. The MiFIR proposals would only allow firms from outside the EU to solicit business in the EU where their home jurisdiction is deemed to have equivalent regulation and offers reciprocal access rights to all EU firms. This is a much higher access threshold than under the existing regime. The proposals also require third country firms that wish to provide investment services to professional clients to do so through the establishment of a physical branch presence in the EU. Given the global nature of activity carried out in the EU’s international financial centres, this restriction is potentially very harmful to market end-users that rely on non-EU firms on a daily basis for their funding and investment needs.
A fifth area where liquidity and regulation interact is in the European Short Selling Regulation, where measures of liquidity are used to determine trigger levels for the temporary suspension of short selling or reporting of net short positions in sovereign debt. A share admitted to trading on a regulated market is considered to have a liquid market if it is traded daily, with a free float of not less than €500 million, and either the average daily number of transactions is not less than 500, or the average daily turnover is not less than €2 million. Under this definition, only 785 shares out of over 6,000 listed on the ESMA website, meet the definition. ESMA is therefore proposing three different trigger levels for non-liquid instruments. So here we see liquidity being defined in a certain way and being used as a means to capture various activities.
Conclusion
So to summarise, liquidity is clearly an important element of a well-functioning market, but it is not a regulatory goal in itself. Integrity, resiliency, efficiency and investor protection are the foremost regulatory goals that need to be considered when designing measures to enhance confidence in markets.
Negotiations among Member States and the EU institutions are well underway in the Council and Parliament on the Commission’s proposed MiFIR text. The Parliament has produced a draft report and amendments from MEPs are to be tabled by 10 May. The Council is also working to produce a compromise text in May. But we expect that negotiations will continue into the Cypriot Presidency. On EMIR, ESMA has published two consultation papers thus far on the technical implementing standards which will need to be finalised by September, ahead of national implementation from January 2013.