A MIFID brainteaser: define liquidity

What do we mean when we say a financial instrument is liquid? That it trades 100 times a day? Ten times a day? Less than that? It’s a question the European Securities and Markets Authority (ESMA) currently has the unenviable task of trying to answer for all non-equity instruments as part of its efforts to draw up detailed rules for the implementation of the revised Markets in Financial Instruments Directive (MIFID) in Europe. Unenviable because a lot is riding on getting the definition spot on – continued market liquidity at current levels for one.

The definition is crucial to much of what is in MIFID and the associated Markets in Financial Instruments Regulation (MIFIR). Liquid instruments will be subject to strict pre- and post-trade transparency requirements, as well as potentially having to comply with an obligation to trade on a regulated market, multilateral trading facility, organised trading facility or equivalent third-country venue.

Under ESMA’s May 22 proposals for post-trade transparency, for instance, information on price, volume and time of trade would have to be made public within five minutes of a transaction in a liquid instrument taking place (although deferrals exist for trades that meet yet-to-be-decided size-specific and large-in-scale thresholds). If an instrument is deemed to be illiquid, however, publication of the most sensitive information is deferred until the end of the following day.

ESMA does have some guidance on how to approach the liquidity definition within MIFIR. A liquid instrument is one where there are “ready and willing buyers and sellers on a continuous basis”. MIFIR also sets a variety of criteria that should be used to determine this: average frequency and size of transactions over a range of market conditions; the number and type of participants; and the average size of spreads, when available.

On a hunch, it seems likely the most standardised parts of the over-the-counter derivatives market may meet these liquid instrument parameters. A study conducted by analysts at the Federal Reserve Bank of New York, based on three months of interest rate derivatives transaction data from 14 large global dealers in 2010, found the most popular interest rate swaps traded up to 150 times each day – a frequency that would presumably meet the continuous buying and selling requirement under MIFIR. However, plenty of instruments barely traded: the New York Fed reported more than 10,500 combinations of product, currency, tenor and forward tenor over the three-month sample, but found approximately 4,300 combinations traded only once during that period.

ESMA’s proposals are meant to weed out these kinds of infrequently traded instruments from the post-trade transparency requirements, with regulators recognising that an overly broad regime could deter dealers from facilitating client trades in less liquid products, causing a further decline in liquidity. ESMA suggests looking at a minimum number of transactions and the number of trading days on which at least one transaction occurred within a certain time frame, alongside the other criteria on average transaction size, number of market participants and spread size.

The critical element in all of this is where the thresholds will be set. ESMA hasn’t yet started its analysis of derivatives data, but it took an initial stab at setting some possible numbers for bonds within its proposal, suggesting six possible combinations. For the minimum number of days on which at least one trade takes place over a year, it suggests a threshold of 120 or 240 days – in other words, the instrument must trade at least once every other day or once a day. That’s combined with a minimum-number-of-trades-per-year threshold of 240 or 480 in all but one of the six scenarios, equating to an average of just one or two trades a day.

It’s clear the choice and combination of thresholds can dramatically alter the proportion of trades classed as liquid. In two of the ESMA scenarios, where the minimum number of trades per year and average daily volume are fixed at 480 and €100,000, respectively, increasing the minimum number of trading days from 120 to 240 reduces the universe of bonds classed as liquid from 4.71% to 1.61% and lowers the percentage of volume captured from 86.67% to 62.90%.

This same kind of analysis will also be performed for OTC derivatives once ESMA has collected the relevant data – and ISDA is working to help pull that information together. In setting the thresholds, it’s likely ESMA has a figure in mind with regards to the percentage of traded volume in each instrument it wants to apply the liquidity requirements – in fact, it says as much in its proposal, noting that it will combine expert judgement with a coverage-ratio-type approach when setting thresholds. Given US regulators set a coverage ratio of 67% for the purposes of the Dodd-Frank rules, it’s not beyond the realms of possibility that ESMA will target a similar level.

The question then is whether the thresholds required to reach this percentage coverage level truly reflect continuous buying and selling activity, as per MIFIR’s requirement. The challenge for ESMA will be in balancing a desire to apply the new transparency rules to a large enough portion of trading volume in each market with thresholds that reflect real liquidity, based on an objective analysis of the data.

All told, a lot of work for both market participants and regulators – and a matter of months to do it in.

Three months left and counting down….

European derivatives users are keenly waiting to discover what derivatives products are likely to be subject to the first clearing mandates, with the European Securities and Markets Authority (ESMA) expected to release its first consultation paper on the topic within weeks.

The process picked up steam back in March, when Swedish clearer Nasdaq OMX was authorized as a central counterparty (CCP) under the European Market Infrastructure Regulation. From the moment ESMA was notified of the approval by the Swedish regulator on March 18, the clock started ticking on a six-month window for ESMA to conduct a public consultation and submit draft regulatory technical standards to the European Commission (EC) for each authorized class of derivatives product it recommends for a clearing mandate.

Since then, four other over-the-counter derivatives clearing houses have been authorized – most recently, LCH.Clearnet Ltd on June 12 – and the current thinking is that ESMA will group together the products it thinks may be suitable for the first clearing obligations, possibly into a single consultation to begin shortly. Furthermore, while the derivatives classes so far authorized for clearing across the five CCPs include interest rate, foreign exchange, equity, credit and commodity derivatives, it is anticipated that ESMA will prioritize the most liquid interest rate and index credit derivatives classes in the first instance.

That approach would seem to make sense, given the six-month window for ESMA to hand its rules to the EC for endorsement is rapidly disappearing. Already, the time set aside for the industry to respond to the consultation is likely to be limited – the first post-consultation draft regulatory technical standards are due to be handed to the EC in less than three months. Those rules will then be reviewed by the EC before being handed to the European Parliament and Council of the European Union for approval.

The good news is that the products likely to be proposed for mandatory clearing first are those where there is already a high level of voluntary clearing and where there is an existing clearing obligation in the US – in other words, the instruments the industry is most familiar with clearing. That may help smooth the consultation process.

But there is still uncertainty about the detail of how the first mandates will be implemented in Europe, meaning every second given to the short consultation process will count.

Frontloading is one such issue where much of the detail will only be spelt out in the consultation paper. ESMA proposed a possible approach in a letter to the EC on May 8, in which the frontloading obligation – the requirement to retrospectively clear existing trades once the clearing mandates begin – would only apply for transactions that occur from the time the regulatory technical standards come into force until the end of any phase-in.

This proposed methodology removes much of the uncertainty that had previously existed, but doesn’t completely eliminate the pricing complexities for end-users during the phase-in period. The switch from non-cleared to cleared would come with an array of potential fee, capital, funding and discount-rate implications, all of which would need to be considered and understood at the inception of any trade during the frontloading period. End-users would also need to find clearing members to commit to clearing at a certain point in the future, which some may be unwilling to do. The fact the date of the switch to clearing would be known in advance under the May 8 ESMA proposal makes that calculation slightly less complicated, but there are still a number of variables that would need to be considered.

Ultimately, the minimum remaining maturity – a level to be set by ESMA that will allow contracts with a time to maturity below this threshold to avoid the frontloading requirement – will be critical in determining the impact. But this will only be fleshed out in the regulatory technical standards. The hope is that market participants will have enough time to absorb, understand and comment on the implications.

This all makes for another busy summer for ISDA and its members.

An Outstanding Question

The semiannual over-the-counter (OTC) derivatives statistics published by the Bank for International Settlements (BIS) have long been closely scrutinised as a reliable barometer of the derivatives market. And the latest figures, released last month, have thrown up some headline numbers that have troubled some commentators.

The overall size of the OTC derivatives market climbed to $710 trillion in notional outstanding at the end of 2013, from $693 trillion six months earlier. This increase, coming on the back of a sharp rise in the first half of last year, has kindled warnings that regulators aren’t doing enough, or that they’ve taken their foot off the regulatory reform pedal.

Nothing could be further from the truth, and a closer analysis of the data explains why. First, though, let’s just recap on what notional outstanding actually represents. It simply measures the total face value of all trades that currently exist, regardless of whether certain trades can be offset or netted against each other. As such, it’s not an accurate reflection of the amount of risk being transferred, the payments that are exchanged between counterparties, or the maximum loss that would be incurred should every outstanding derivatives contract be closed out – a point regularly acknowledged by the BIS in its studies.

In contrast, gross credit exposure – which measures the gross market value of outstanding derivatives after legally enforceable netting is taken into account but not considering the impact of collateral – actually fell from $3.8 trillion in June 2013 to $3 trillion six months later. Including the collateral that counterparties have posted to each other would reduce that exposure even further.

But even recognising what notional outstanding represents, and the limitations of what it tells us about derivatives risk exposure, there are some technical issues that need to be kept in mind. Most significantly, the BIS figures count each cleared trade twice: one between counterparty A and the central counterparty; and one between counterparty B and the clearer. A single $10 million trade between two parties subsequently cleared therefore becomes $20 million in notional outstanding for the purposes of the BIS data.

To adjust for that, the outstanding notional volume of cleared trades (themselves adjusted for double counting) would need to be subtracted from total notional. Looking at interest rate derivatives alone, approximately $226 trillion in cleared notional at the end of 2013 would need to be subtracted from the $584 trillion in interest rate derivatives notional, leaving $358 trillion. That’s more or less unchanged from the adjusted interest rate derivatives figure six months earlier. In other words, new regulation, and in particular, the push for greater amounts of centrally cleared trades, is the driver behind much of the apparent increase in notionals.

Nonetheless, a lot of work is being done to reduce the size of these figures. Compression has already reduced the outstanding notional of cleared and uncleared derivatives by $453 trillion as of April 2014, according to figures from Stockholm-based TriOptima. Industry efforts are under way to build on that – in part to reduce the operational burden for dealers, but also encouraged by regulations like the leverage ratio under Basel III, which sets capital based on gross notional, rather than net risk, exposures.

Far from taking their foot off the pedal, then, regulators have introduced rules that are very much driving these numbers. With clearing leading to double counting of notional, and compression cutting back on gross exposures, it’s difficult to know which way the next BIS numbers will run. One thing’s for sure, though – the notional figures reported won’t be an accurate reflection of risk.