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MiFID: Why not just stop?

Why is a piece of regulation which nobody wants, which the massed sovereign debt offices of Europe oppose, and which the regulator itself admits will barely work pushing remorselessly ahead?

Trading bonds doesn’t get people angry. Bankers’ bonuses, bail-outs, “betting with other people’s money”, and taxpayer guarantees all, often rightly, get people fired up. Sometimes they pitch tents near stock exchanges, sometimes they write to their politicians, but there is palpable public anger.

The microstructure of trading is different. Ask The Man on the Street whether bonds should be traded electronically, on exchange, with trade disclosure or not, and be prepared for a big fat nothing.

Which makes it all the more puzzling that European authorities are pushing ahead with the most sweeping set of reforms to bond trading in history, and on a furiously fast timetable. Nobody asked for this, and it is tough to argue that it makes the world safer.

What’s more, the European Securities and Markets Authority, the regulator in charge of implementing the reforms, has extensively studied the issues — and come up with a solution which its own analysis suggests is deeply flawed.

The problem regulation here is MiFID II, the Markets in Financial Instruments Directive and Regulation.

It is a massive document, which turns much of the infrastructure for financial markets upside down, and ESMA’s latest publication is only the latest step in the extensive round of consultation and redrafting that is supposed to produce a final text by the middle of this year, for implementation in January 2016.

In the world of bond trading, it attempts to introduce equity-style transparency to the market, mandating dealers to report the price, volume and time of trades soon after they are made, and to make executable prices available to the whole market, rather than just the client requesting a quote.

The problem though is the structure of the bond market, which will see dealers forced to publish these details while they are still likely to be holding the risk.

Plenty of market participants, including all of Europe’s public debt offices, argue that this would destroy bond market liquidity. When only a fraction of bonds are remotely liquid, forcing dealers to make transparent prices and publish trades afterwards would push bid-offers wider or encourage dealers to leave the market entirely.

ESMA has said it is indeed concerned about this, and has studied the bond market in detail.

Instruments deemed “illiquid” have better treatment under the proposals — less transparency before and after the trade (or longer delays, to allow dealers to hedge or trade out before they have to disclose).

For its analysis, the regulator has used an extraordinarily lenient test for liquidity — bonds which trade on €100k average daily volume, see more than 400 trades a year, and trade on more than 200 days in year.

Unsophisticated standards

Unfortunately, there is nothing so sophisticated in its latest proposed technical standards. Instead, a crude issue size serves as a proxy for liquidity. Sovereign bonds over €2bn are liquid. For other public sector bonds, the threshold is €1bn. Covered bonds, senior corporates and financial converts above €750m are liquid; financials and subordinated bonds over €500m are liquid.

But the regulator itself says that these categories produce huge proportions of errors. Some 73.55% of covered bonds above the size threshold do not meet ESMA’s own liquidity test, 42.43% of the sovereign bonds also fail.

ESMA manages to plump these percentages up by noting that its test correctly categorises all the illiquid instruments as illiquid. Adding these in improves the accuracy of the sovereign bond test to 88.54% — still hardly a confidence-inspiring number.

It has other safeguards, including carve-outs for especially large trades, which could soften the blow, but this rate of failure is astonishing, and would not be tolerated anywhere else.

ESMA rightly notes that categorising bonds by issue size, rather than through a more nuanced, ISIN by ISIN approach, is much simpler and imposes a smaller reporting and compliance burden. But the liquidity problems it will create will wreak havoc.

At the dark heart of European Union policy making is a question which nobody in the regulatory apparatus asks: why not just stop?

Other than the momentum which any large piece of regulation generates, there is no “natural MiFID constituency”. No MEP will lose their seat because of it, and the Commission and Parliament which started the project are both long gone.

It will make the banking system more dangerous, not safer, by squeezing liquidity, just at a time when banks are being asked to fill their boots with bonds to sell in times of trouble.

Some projects — such as the rehabilitation of securitization — appear to capture the political imagination in Europe. Others, like MiFID, just rumble on. The new Commission has made an admirable commitment to “proportionality and subsidiarity”, two founding principles of the EU which could allow it to slink away from the Likannen structural reform proposals.

But before it is too late, Europe’s policymakers need an urgent review of MiFID. And if they aren’t sure about what is ahead, it’s time to put on the brakes.

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