How does MiFID II propose to reshape the bond market?
When it comes to fixed income, MiFID II essentially aims to shed some light on a market that is primarily traded over-the-counter and characterised by opacity.
The final MiFID II text is still being debated and the proposals on fixed income could change but the core of the legislation seeks to impose better pre- and post-trade transparency obligations for fixed income trades.
At present, to trade a bond a buy-side trader must call a bank or broker that acts as a market maker in the instruments they want to trade and request a price. However, the price the trader obtains is only indicative and may have shifted even if the order is placed minutes after requesting the quote.
MiFID II proposals seek to make such quotes 'firm' and disclosed to the wider market under some circumstances.
Post-trade reporting for bonds is practically non-existent in Europe. It appears as though European policymakers want to install a system similar to the TRACE reporting mechanism established in the US for corporate bonds.
What would the buy-side gain from added bond transparency?
The obligation to provide firm, pre-trade price quotes offers more certainty to buy-side traders on the price of bonds and will also help them to better compare quotes offered across the banks they deal with.
Imposing post-trade transparency would offer the buy-side a way to assess the performance of their trades compared to others in the market. The ultimate aim of MiFID II is to introduce a consolidated tape for fixed income, but attempts to establish a similar solution for equities have so far proved unsuccessful.
Surely imposing this level of transparency on a market that has hitherto operated OTC could be damaging?
Although the MiFID II proposals recognise that transparency for fixed income needs to be appropriately calibrated in order to deal with the liquidity characteristics of the asset class, banks have been quick to air their concerns – partly due to the loss of control and influence they will have on fixed income markets going forward.
Just last week, broker trade body the Association for Financial Markets in Europe (AFME), in conjunction with consultancy Cicero, polled buy-side traders on the potential impact of the MiFID II proposals to date.
The survey revealed that 56% of institutional investors believe the compulsory disclosure of firm quotes would lead to a decline in trading volumes, a reduction in trading size, a rise in trading costs or a stop to trading altogether.
Market participants have also indicated the need for post-trade transparency in fixed income to be designed in a way that reflects the way bonds are traded.
As bonds are traded OTC, brokers take positions on their own books on behalf of their buy-side clients and unwind them accordingly. If instant reporting is required for large trades, dealers may find the market moves against them as they are unwinding their position. Banks believe this would shrink the average trade sizes for bonds and cause some dealers to exit the market altogether.