For the European derivatives market, 2015 is set to be the year in which the final pieces of the regulatory jigsaw are finally put in place, comprising rules on electronic trading, transparency and margin, as well as the implementation of central clearing for standardised swaps.
While mandatory clearing of interest rate swaps is set to begin early summer, the big source of debate for European regulators remains which specific securities will be mandated to trade on venues or subject to pre-trade and post-trade transparency under MiFID II.
In its final consultation, published in late December, the European Securities and Markets Authority addresses the most important parameter in making those decisions – the liquidity of specific instruments.
“A critical part of the MiIFID II/MiFIR framework is the process for determining whether an instrument is liquid,” says Roger Cogan, head of European public policy at ISDA. “Getting the thresholds wrong and capturing less liquid instruments could potentially result in market-makers being less willing to provide liquidity to clients, given concerns that other market participants could use the public data to trade against them.”
ISDA, in a July submission to ESMA, said that in practice liquid should mean instruments that trade at least 15 to 40 times a day (see “ISDA sets out stall on MiFID liquidity debate”, IFR 2045). In its final proposals, ESMA says that a liquid instrument should be broadly calibrated by two measures: frequency and size of transactions.
The regulator examined 15,976 rates instruments provided by four trading venues from June 2013 to May 2014, including bond futures, interest rate futures and interest rate options. Only 17% of the instruments had any trading during the period, ESMA notes.
Liquidity conundrum
To be considered liquid, a class of on-exchange interest rate derivatives must trade on average once per day or more and with an average notional amount per day of at least €5m, ESMA says. That means nine instruments categorised as long Bund futures are deemed liquid on the Eurex platform, while all ICE-listed short gilts futures are considered illiquid. Only five of 22 classes of ICE-listed Swapnote futures are considered liquid.
For OTC contracts, the definition of liquid for any class of derivatives is an average notional amount traded per day greater than or equal to €500m, the number of days traded greater than or equal to 80% of the available trading days in the period and the average number of trades per day greater than or equal to 100.
ESMA divides liquid classes into sub-classes, of which there are 829 in the single currency fixed-to-floating swap class, and decides the liquidity of each sub-class based on trades per day thresholds ranging between one and 10. For fixed-to-floating swaps, based on a trades-per-day threshold of two and a notional-per-day threshold of €100m, some 247 liquid sub-classes, or 90% of the trades, are captured, representing 97% of gross notional.
ESMA is kinder to inflation swaps, finding just six sub-classes liquid, based on one trade per day and €50m thresholds, representing 19% of trades and 26% of notional.
The thresholds are considerably lower than those proposed by ISDA, which in July set out its preference for a 20 trades-per-day floor and also tabled a scenario with a trade frequency floor set at 10 per day, which captured 44% of the market in notional across 40 instruments – still short of the 67% coverage sought by the CFTC.
“The December consultation is the meat on the bone of the MiFID proposals and market participants must sit down and fully understand the detail because this is the last chance to make a difference,” says Tim Dolan, a London-based partner at law firm King & Wood Mallesons. “In terms of specific business impact, the analysis starts now.”
Waivers
Additional waivers are provided for so-called trades considered large in scale (LIS) or outsize in terms of size specific to the instrument (SSTI).
Under LIS and SSTI, transactions can get a waiver or partial waiver of pre-trade price discovery and of post-trade reporting, with the latter extended to 48 hours after execution (with national regulator discretion for up to four weeks for volume information), compared with 15 minutes for conventional trades.
Various thresholds are set for individual classes of instruments but for interest rate derivatives the LIS threshold floor is set at €10m and the same level is set for government bonds. The threshold is set at €2.5m for financial bonds and €1.5m for non-financial senior debt. The SSTI threshold, a kind of waiver-light option, is set at 50% of the LIS level.
The LIS thresholds represent trades that are larger than 90% of the market, but still some market participants say they are unreasonably punitive.
“The LIS and SSTI floors are rather high,” says Sidika Ulker, London-based director at the Association for Financial Markets in Europe. “If you think, for example, that the average transaction size for corporate bonds is around €150,000, then it’s pretty clear that very few trades are going to be eligible for the waiver.”
For request-for-quote and voice trading systems the SSTI waiver is applied. SSTI is also applied to systematic internalisers (market-makers), with trades below those thresholds requiring firm actionable pricing offers to all clients.
Further, ESMA will face challenges in quantifying LIS, Ulker says.
“It’s clear that information will be needed on trading volumes and frequencies across the market but it’s not obvious where that will come from. Even if Europe gets a consolidated tape, some of the volume information will not be available for an extended period, so there needs to be another place and if you read the technical advice, ESMA does not see itself undertaking the job.”
