Chris Hall explores the five primary concerns that credit traders have about MiFID II.

“MiFID II is not yet in force, but its impact is already very much in evidence, notably in spread products,” says Jutta Schneider, head of fixed income trading at Allianz Global Investors (AGI).“Prominent banks are leaving their core markets,while trading venues are evolving their value propositions. Where once was certainty, now we regularly ask ourselves: who will quote on which products?”

Even before the proposed delay to MiFID II’s roll-out, the directive/regulation was far from the finished article. The final version was effectively laid out by the European Securities and Markets Authority (ESMA), which issued its revised draft regulatory technical standards (RTSs) on 30 September 2015 – including multiple tables outlining criteria, calibrations and exemptions. As noted by Schneider, the new directive and its attendant regulation are already making their presence felt. Yet Europe’s buy-side credit traders need answers in five key areas in order to complete their preparations.

1. Defining liquidity

How you trade corporate or sovereign debt under MiFID II will be determined primarily by the liquidity of the individual instrument. From January 2017, a bond will be deemed liquid if its average daily notional amount is 100,000, it trades at least twice a day on average, and is actively traded for 80% of the calibration period, i.e. the previous calendar quarter. A new list of liquid bonds will be published by ESMA on the first day of February, May, August and November each year, coming into force two weeks later. ESMA will publish its first assessment next December.

Although existing debt will be categorised based on this instrument-by-instrument approach (IBIA), new issues will be assessed on size, with sovereign bonds under €1,000,000 and corporate bonds under €500,000 automatically classified illiquid. This ‘classes of financial instruments approach’ (COFIA) will apply for between the first 2.5 and 5.5 months after issue, before switching to IBIA.

Electronic market operator MarketAxess has found an analysis of its Trax database suggests around 5% of European corporate credit issues will qualify as liquid by international securities identification number (ISIN) count, equating to between 22% and 38% of active issues by traded volume. For European sovereign bonds, around of a quarter of actively traded ISINs would be liquid, equating to around 90% of all traded volume. Based on a further analysis of new corporate issues, MarketAxess says the number of false positives generated by COFIA – i.e. new issues incorrectly categorised as liquid – would be reduced to around 10% of ISINs if the threshold was raised to E1,000,000.

“IBIA will provide a more accurate picture than COFIA, but it’s undoubtedly more complex and time-consuming to implement. The impact on buy-side firms will be influenced by their overall investment strategies. A house with a short-term strategy will likely be dealing in a higher proportion of liquid bonds than a pure buy-and-hold house,” says Adrian Berwick, head of trading, Dublin and London, Pioneer Investments.

2. Pre- and post-transparency

This quarterly recalibration is important because liquid instruments will have the most stringent pre- and post-trade transparency requirements under MiFID II. “When trading bonds (on venues) that are subject to pre-trade transparency requirements, buy-side traders must – prior to execution – make public the volume, the price and the ISIN for the transaction, and how they intend to unwind it. This could have a challenging impact on the ability to deal,” says Arjun Singh-Muchelle, senior advisor, regulatory affairs (institutional & capital markets) at the Investment Association.

Regardless of liquidity designation, transactions below E100,000 are excluded from any pre-trade transparency requirements. Also, national competent authorities (NCAs) can grant pre- and post-trade transparency waivers for trades above the size specific to instrument (SSTI) and large in scale (LIS) thresholds set by ESMA on 30 April each year. To start, ESMA has set the SSTI pre-trade waiver at the value at which the 60th percentile of trading activity takes place, with the LIS set at 70%. Beyond this, different transparency rules apply to trading venues, according to the trading protocol used, while the rules for bilateral trading – via systematic internaliser (SI) or OTC – vary again.

In terms of post-trade transparency, trades involving liquid bonds must be printed within 15 minutes (and after five from 2020). Printing of illiquid bonds or those subject to exemptions can be deferred until 7:00pm the next trading day. NCAs have discretion to allow further delays.

“When trading bilaterally with a broker that is not registered as an SI, the buy-side firm will have to fulfil the post-trade transparency obligations itself. Many buy-side firms have not woken up to this obligation or to the costs they may incur, or the compliance implications, if they ask their sell-side counterpart to do it for them,” says Miranda Morad, European general counsel, MarketAxess.

3. Reporting

As well as pre- and post-trade transparency rules, MiFID II imposes new transaction reporting requirements on the buy side. Transactions, instruments, entities and individuals must be identified and reported to NCAs, preferably via an approved reporting mechanism. Because the reporting requirements are contained within MiFIR rather than the directive, they are directly applicable with no local transposition. Buy-side firms may need to obtain legal entity identifiers, but can leverage any investment in reporting made under the European Market Infrastructure Regulation (EMIR). Firms may delegate reporting, so long as they have suitable oversight mechanisms in place.

MiFID also requires the buy side to provide underlying evidence of best execution and maintain a regularly updated best execution policy document. “There will be additional costs associated with the information that investment managers will be required to provide for unit holders and fund clients under Article 28 best execution requirements. These could be pretty considerable for mid-tier firms and arguably the extra data required might not be as meaningful to clients as other information that should be contained in a best execution policy, for example on asset allocation and the type of instruments invested in,” says Singh-Muchelle.

While the data challenge of MiFID cannot be under-estimated – in terms of sourcing, capturing, storing and reporting different types of data along the transaction chain – the resulting transparency could be beneficial.

“Price discovery in Europe is far too reliant on dealer-to-client RFQ processes. MiFID II will give rise to broader access to pricing information, which will give the market greater confidence to trade using a wider range of protocols, including all-to-all,” says Gareth Coltman, head of product development, Europe, at MarketAxess.

4. Venues

There are still too many decisions pending to be sure how credit trading preferences will evolve. Seen as a voice-based market, credit has quietly gone electronic in recent years; Schneider estimates around 85% of AGI’s fixed income business is done on trading venues. While concerns still arise about how RFQ-based platforms will adapt to pre-trade transparency requirements, there is far more certainty around these venues, typically multilateral trading facilities (MTFs), than the newer organised trading facilities (OTFs) or the SI frameworks that large banks must implement for instruments in which they are major liquidity providers.

OTFs are seen as the natural home for voice-broked, OTC bilateral business, but would-be operators are struggling with other restrictions – matched principle trading is not permitted – especially if they are planning to run an SI too. Some have questioned the appetite of banks to supply liquidity via SIs in a wide range of liquid ISINs, but Kate Finlayson, head of market structure, FX, rates and credit, clearing & execution services, at UBS, suggests a more pragmatic reason for delaying clarification of their status under MiFID.

“Although the substantive qualifications of an SI are now set out, the missing piece of the jigsaw for investment firms that may fall under this qualification is their levels of trading activity in the financial instruments vis-à-vis the total nominal traded in that same instrument across all EU trading venues,” she notes.

Furthermore, Finlayson asserts that further regulatory input is needed before banks can decide how best to supply liquidity to their customers. “Following a revision to the definition of a RFQ venue, our understanding is that the requestor is the only party that is able to trade against a quote.

However, the pre-trade disclosure requirements for Systematic Internaliser RFQs haven’t changed. SIs are still required to publish their quote to all their clients when they provide an off-venue quote to the requestor.”

She notes that the impact of pre-trade disclosure in the credit world is limited to those trades which transact via voice, away from venues and so not the RFQs on platforms such as Bloomberg, MarketAxess or Tradeweb for example.

“Trades executed via voice tend to be those in larger sizes, so getting the size specific to instrument (SSTI) thresholds right will be key,” she adds. “On the rates side, the trading obligation will have more of an impact than pre-trade disclosure, given that the trading obligation of certain OTC derivatives will shift trading in those instruments on to venues anyway.”

5. Unbundling

MiFID II represents the extension of an equities-based regulatory framework to the wider securities market, notably in terms of efforts to separate research payments from execution fees. The new regime for unbundling is still subject to final confirmation by the European Union, but the credit and other markets are playing catch-up.

Eric Böss, head of derivatives at Allianz Global Investors, says: “There are too many differences between equities and fixed income to impose the same solution to unbundling on both markets. Equities is a commission-yielding business with relatively high research costs, while fixed income is spread based and has comparatively low research costs. As such, research payments is a second-tier issue in the fixed income market, and one that may require a different approach by regulators.”

MiFID II’s rules on research payments might represent the culmination of a decade-long evolution toward a more transparent process on equity desks, but for credit it is more of a leap in the dark. “While commission-sharing agreements (CSAs) are well established in equities, this is not a process predominantly used in the FX, rates and credit world,” says UBS’ Finlayson.

“As such clients are having to assess their use of research and the value they ascribe to it for the first time. We’re working with clients to develop a framework for their use of research that can be used under MiFID II, which may require the creation of research payment accounts or the use of enhanced CSAs, depending on what is set out in the European Commission’s Delegated Acts and how NCAs interpret the requirements.”

©The DESK 2016