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Apart from central bank and market initiatives, a number of measures in the field of financial regulation, which are intended to prevent another crisis on the scale of the one we have just witnessed, have been decided upon or initiated by various authorities. Such measures contribute to structural changes in the institutional set-up of financial markets and are expected to restore market confidence and, ultimately, to support growth.
Yet the intended positive effects of regulatory measures have to be carefully weighed against their costs and unintended side effects. Market participants point out that the regulatory measures must be consistent with one another. The speed of regulatory innovation should not mean that too little consideration is given to the impact one measure will have when taken in conjunction with others. Also, consistency on the international level has to be ensured.
Very importantly, financial regulations should be designed and implemented carefully in order to avoid potentially adverse effects on market liquidity and price formation. For the ECB, efficient, resilient and liquid financial markets are a key prerequisite for the smooth implementation and transmission of monetary policy. The ECB therefore strives to ensure that regulatory reform initiatives do not impose restrictions which may hinder the efficient functioning of markets or impair their liquidity.
A number of regulatory measures target financial markets. Let me focus in the rest of my speech on a very important regulatory initiative and on a concrete example: the review of the MiFID II and, specifically, the proposed price transparency requirements. The ECB also provided an opinion on the MiFID II proposal.
As you know, the MiFID II proposal extends pre- and post-trade transparency requirements from equity instruments (MiFID I) to additional asset classes such as bonds, structured finance products, derivatives admitted to trading or traded on a regulated market, a multilateral trading facility or an organised trading facility and derivatives considered eligible for central clearing. The aim is to enhance price formation and to support the evaluation process of such instruments.
The requirements cover pre-trade transparency – i.e. the provision of quotes and market depth to market participants ahead of a trade – and post-trade transparency – i.e. the timely publication of the prices and volumes upon trade execution. These mandatory transparency requirements represent a major change, especially for the fixed income market. For brevity, I will only address the issue of post-trade transparency.
As we have known since the publication of the seminal work of the Austrian economist and philosopher Friedrich Hayek, prices reveal information that is dispersed among the numerous individual members of an economy. As a consequence, market outcomes are directly influenced by the time and degree to which prices and volumes are disclosed to the public.
In reality, different markets are subject to different transparency regimes and disclosure requirements, which are a consequence of the existing heterogeneity among both financial assets and market participants. While this implies that a one‑size-fits-all level of transparency is unlikely to exist, a number of economic forces are omnipresent and therefore allow us to draw some conclusions from the academic literature on post-trade transparency.
In those market segments that the MiFID II review aims to address, liquidity providers play a central role as they intermediate between end investors and thereby help to secure a well-functioning marketplace. Yet an efficient and resilient market requires a sufficient level of competition. Several studies show that a lack of transparency can be a serious threat to a level playing field because intermediaries may use their private knowledge of customer order flow as an informational advantage that allows them to exert market power. Therefore, opacity enables the extraction of rents and can lead to increased price dispersion, with negative consequences for market integrity and fairness. Furthermore, a low level of post-trade transparency can significantly distort the informational role of prices by preventing the diffusion of value-relevant information, which may hamper market liquidity because of adverse selection.
In line with this rather positive view of post-trade transparency, a number of empirical studies have found that the introduction of mandatory trade reporting has significantly improved formerly opaque market segments, such as the market for US corporate bonds. At the same time, one must be aware of potentially negative side effects. For example, liquidity providers may be reluctant to take on a large inventory position because they will find themselves in an unfavourable bargaining position if this information is known to others. They may ask for an additional premium in order to take on such a risk, which can raise transaction costs for investors. Similarly, very large market participants, such as pension funds, may find it more difficult to execute large transactions without being front-run by predatory traders. In very transparent markets such as those for equities, this has become a substantial concern.
With these issues in mind, it is imperative that the new regulatory environment carefully considers all possible implications of increased market transparency. In particular, it is important that the new set of rules is calibrated in a way that avoids excessive market liquidity distortions, in particular in those market segments whose functionality is still partially impaired as a consequence of the market disruptions that we have witnessed over recent years.
With this in mind, the ECB explicitly welcomes private sector initiatives such as the AFME framework for post trade transparency, which I believe is a constructive proposal because it aims to fine-tune the reporting requirements across different liquidity categories, something that is certainly a sensible approach given the economic trade-off I have just outlined.