Banks Win Fight on Liquidity Test in EU Bond-Market Overhaul

  • ESMA Proposes Bond-by-Bond Approach to Determining Liquidity
  • Liquidity Determines If Bonds Are Under Price-Disclosure Rule

European Union regulators changed key aspects of proposed transparency rules for the bond market after banks objected to the method proposed for determining which securities would fall under a price-disclosure requirement.

The European Securities and Markets Authority published technical standards on Sept. 28 that detail how it will determine which bonds are liquid and subject to rules for disclosing pre- and post-trade bid and offer prices. ESMA chose a bond-by-bond approach, rather than looking at classes of securities as first proposed.

“Many respondents” in a public consultation on its initial proposal, “mainly from the sell side,” pushed for the “instrument-by-instrument approach,” ESMA said. Some support for the class-based approach was received from exchanges and asset managers.

The Paris-based regulator “has responded to concerns raised by the industry that ESMA’s original proposals would have damaged price formation and potentially caused liquidity to dry up in the bond market,” said Michael Thomas, a partner at law firm Hogan Lovells. “As a result, ESMA has adopted the industry’s preference for measuring bond liquidity using” the instrument-based method.

Financial Crisis

The EU, seeking to prevent another financial crisis, is implementing rules designed to shift trading on to exchanges where regulators can track it and to boost transparency to protect individual investors and level the playing field for professionals. The new requirements, part of a wide-ranging series of changes in financial markets regulation, are the second iteration of rules that are already a cornerstone of European financial market regulation and will apply in practice from January 2017.

In fixed income, EU law goes further than the U.S.’s Trace bond-price reporting system, where trades are reported only after they have taken place. Reporting requirements, both before and after trades take place, will apply to about 2,000 most-liquid securities out of about 50,000, with the precise amount changing depending on trading levels. Most of the bonds affected are sovereign securities, ESMA Chair Steven Maijoor told reporters.

‘Best Measure’

The bond-by-bond approach is “the best measure of the individual liquidity of a bond,” Maijoor said. “We’ll work on this basis and see how that develops in practice.”

“There were genuine concerns about misclassification risk for individual bonds under a category-based approach,” said Damian Carolan, a partner at law firm Allen & Overy. “Given the novelty of the regime, there was real risk that over-extensive transparency requirements might be difficult to identify and roll back on a timely basis, and might cause long-lasting impact for instruments which were inappropriately caught in the first instance.”

ESMA plans to assess the liquidity of bonds on the basis of the average daily amount traded, which should be at least 100,000 euros ($112,000), an average of at least two trades daily and trades taking place on at least 80 percent of trading sessions. Newly issued instruments will be deemed liquid depending on their size.

Significant Impact

Arjun Singh-Muchelle, senior adviser on regulatory affairs at the Investment Association in London, said the increase in the number of times a bond needs to trade to be seen as liquid “means less bonds are affected by the regulation than previously thought. This is going to affect sovereigns more than corporates, but large corporates will still be significantly impacted.”

“The transparency regime on bonds seems to have moved significantly from ESMA’s initial proposals,” said Liz Callaghan, director for secondary-market regulatory policy at the International Capital Market Association. “ICMA would have liked to have seen trades below 100,000 included in the liquidity calculations. The key now will be how all of this will be implemented in practice and how nimble it will be.”

While looking at individual bonds avoids false positives and negatives at the time of calculation, a liquid instrument might become illiquid, or vice versa, during the quarterly period on which the calculation is based. The evaluation can be corrected at the end of the period, when the status of the security is reviewed, ESMA said.

Approval Procedure

For example, $759 million of bonds of Volkswagen AG traded on Sept. 21 when the carmaker became the target of a U.S. criminal probe, compared with average daily trading of about $77 million in the three months prior, Trax, a unit of MarketAxess Holdings Inc., said by e-mail.

The European Commission, the EU’s executive arm, now has three months to endorse ESMA’s standards. If the Brussels-based commission wants changes, ESMA has six weeks to comply. And if ESMA doesn’t follow instructions, the commission can adopt its own version or reject the rules.

Once the commission has signed off, the European Parliament and the EU’s 28 member states have as long as six months to object to the standard, and there won’t be a rubber stamp.

The finance ministries of Germany, the U.K. and France last month expressed doubt that either liquidity methodology -- by bond or by class -- considered by ESMA was consistent with the EU law, known as the Markets in Financial Instruments Regulation, which the regulator’s standards are meant to flesh out.

‘Mammoth Task’

The three ministries expressed concern that in “a number of important areas,” ESMA and the commission, which is also drafting standards, had lost sight of the laws already on the books.

In parliament, lawmakers have raised similar concerns.

“Both ESMA and the commission would be naive to think that after we have all spent so much time working on the level-one regulation of MiFID II, that we would simply sit back and let them reinterpret things that we are certain were agreed,” Kay Swinburne, a British member of the assembly, said before the Sept. 28 publication. “ESMA has a mammoth task to ensure it does not exceed its mandate and that it does the necessary work to get the measure right down to the smallest detail.”

Maijoor said the technical standards announced by ESMA on several EU laws “will notably change the way Europe’s secondary markets function,” and this will affect both markets and regulators.

The magnitude of the change “should not be underestimated,” he said. “But the past has taught us that change is needed in order to make markets more transparent, efficient, and safer to invest in. This will entail a certain cost but we should not forget the other side of this equation, which is the great benefits safer and sounder markets will bring to everybody.”

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