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.

The euro swaps surprise

As surprises come, it should have been a non-event. On March 18, Swedish clearing house Nasdaq OMX announced it had been authorised as a central counterparty (CCP) under the European Market Infrastructure Regulation (EMIR), the first in Europe to get the regulatory nod of approval. Clearers had to submit their applications by September 15 last year, and national authorities had a six-month limit to consider them once they were confirmed as complete, meaning the authorisation was well in line with the schedule outlined by the European Securities and Markets Authority (ESMA).

Nonetheless, the announcement caught the market completely unawares, and has led to a situation where European derivatives users are unsure how to price and risk-manage euro-denominated interest rate swaps, the largest segment of the interest rate derivatives market.

How did this happen?

It all boils down to the oddly named and much misunderstood frontloading requirement under EMIR. Frontloading is a bit of a misnomer – it actually refers to a requirement to backload certain derivatives transactions to a CCP, specifically those trades conducted between the point in time ESMA is told a clearing house has been authorised to clear certain derivatives classes and the start of a clearing obligation for those products.

The problem arises because it’s uncertain which trades will be captured by this requirement, and when. Once ESMA is notified of a CCP authorisation, it has six months to conduct a consultation and draw up regulatory technical standards for each class of products it thinks may be suitable for mandatory clearing. The European Commission (EC) then has up to three months to endorse the standards, before they pass to the European Parliament and Council of the European Union, which have up to two months to accept the rules if they haven’t been modified by the EC and up to six months if they have. The rules are then published in the official journal, and come into force 20 days later.

According to a time line published by ESMA last year, the earliest a clearing mandate will come into effect after a CCP is authorised is nine months; the latest is 16 months. But there could be phase-ins written into the rules that extend the start date beyond that.

This all matters because Nasdaq OMX doesn’t just clear the smaller Scandinavian currencies – it also clears euro interest rate swaps. That means the clock is now ticking, and any euro swap transacted by a European participant from March 18 onwards may need to be backloaded to a CCP at some unknown time in the future.

This creates some real risk management headaches for European derivatives users. Should individual trades now be treated as cleared, non-cleared, or a mixture of both? It’s virtually certain a clearing mandate will apply for euro interest rate swaps at some point, but it’s not clear when. The situation is even less clear for other, less liquid products – ESMA may decide after its consultation period that some instruments are not yet suitable for mandatory clearing, particularly if they are only cleared by a single CCP.

Market participants had hoped regulators would provide further clarity on frontloading before the first CCPs were authorised. Without this guidance, derivatives users can’t be sure whether any single trade will ultimately be subject to frontloading or not. That’s why the approval of Nasdaq OMX came as such a shock.

Further clarity will come at some point. But the sooner the better. Until it does, uncertainty will continue to hamper risk management in the euro swaps market, making it more difficult for end-users in Europe to implement the hedges they need.

Should I stay or should I go?

Everyone knows that two of the busiest days around the office are the day before you leave on vacation and the day you return. For some of us at ISDA today is getaway day, but that doesn’t mean there isn’t time to spare a few thoughts on the current state of the derivatives markets.

We had something of a “July Surprise” with the announcement on July 11 that peace was at hand between the CFTC and European regulators on cross-border derivatives regulation. We viewed that announcement, as many people did, as a positive development and a serious attempt to advance the discussion of global regulation of a global business.

As is often the case with broad pronouncements, however, the detail is in the detail, to coin a phrase. The next day the CFTC provided its final guidance on cross-border issues and additional time for compliance under an exemptive order. It is clear from the detail that the process of determining substituted compliance is going to be a critical one. It will be important to get both the substance and the process right. You will be hearing more from ISDA on this in the days ahead.

The CFTC work plan for derivatives is largely complete, with the finalization of the cross-border guidance and the publication earlier in the summer of SEF rules and related rulemaking. We will continue to work through the implementation challenges our members face, including the third wave of mandatory clearing in early September, but the drumbeat of deadlines is fading on the US front.

But don’t think it will be a vacation from here on out — far from it. Still, at least there will be a change in locale — Europe in particular, but all over the globe as well.

Europe is considering its approach to mandatory clearing and our various product steering committees are reviewing ESMA’s discussion paper. Confirmations and portfolio reconciliation face mid-September deadlines. And the European approach to the G20 commitment on execution will be hashed out over the course of the Fall through the consideration of the Markets in Financial Instruments Regulation in the trilogue process. We will be actively engaging with policy makers to identify areas with particular market sensitivity.

Globally, we are expecting approval by the G20 of the proposals on margin for uncleared derivatives. We have written extensively, both in derivatiViews and in submissions to regulators, about our significant concerns with the proposed initial margin requirements. It seems clear that initial margin in some form and quantum will be required, so we are also working on the development of a standard initial margin model to facilitate the introduction of any initial margin that might be required. Whatever the G20 decides will need to be implemented at national levels, so this issue is going to be on the front burner for months to come.

There are other things that await your return from vacation — major regulatory capital proposals, consideration of benchmarks, new credit derivative definitions, to name a few. In a few weeks, as summer ends (or winter for those of you in the southern hemisphere), and you feel the need to quickly get up to speed on all the developments affecting derivatives, consider attending our annual regional conferences in New York or London in September or in Asia in October. Details are on our website.

Wherever you may be headed—or even if you are staying put—safe travels and we look forward to your continued involvement and support.

Liquidity Is King

While it is summertime, the livin’ is not (always) easy. The EU regulatory process continues unabated and with the publication of a first complete Compromise Text on MiFID 2/MiFIR earlier this summer, the journey to trading obligations and platforms in the EU has well and truly begun. The process will take another step forward with the ECON Committee vote in the European Parliament, scheduled (after a postponement) for late September.

One of the big questions that remains unanswered in the MiFID/MiFIR debate – and that explicitly needs to be addressed before its resolution – relates to liquidity.

There are two aspects to this issue. One has to do with the use of liquidity as a benchmark or trigger for determining whether a rule applies to a particular obligation. The second has to do with the impact of the rules on the liquidity of traded financial instruments.

First things first: On the subject of a liquidity trigger, at what point should a financial instrument or market be considered liquid enough to support particular regulatory obligations? Such obligations might include those related to mandatory central clearing of OTC derivatives; mandatory trading of derivatives on regulated venues; or pre- and post-trade public transparency. That question is at least in focus in the MiFIR debate. Much less attention is being paid to an equally important question: when does an instrument or market stop being liquid enough to support those obligations; and how do you suspend them?

This is not just an academic discussion. Various provisions in the MiFID/MiFIR proposals reference liquidity as a trigger for particular obligations (notably the trading obligation and pre-trade transparency requirements).

Moving now to the second issue, the impact of the proposed rules on liquidity: To what extent could additional regulatory obligations increase or impair the existing liquidity of a particular financial instrument or a market as a whole? To be fair, some policymakers show awareness and sensitivity to this issue.

In the continuing dialogue over the proposed rules (particularly over the trigger issue), it is important that policymakers consider the potential for liquidity to vary over time. To put it bluntly, there is no market where permanent liquidity can be guaranteed (or, by the same token, mandated). This might reflect changes in market conditions in general, or simply the nature of the individual product.

Changes in liquidity levels could be inherent to the product in question, with liquidity falling in the period after the conclusion of the contract. For example, an ‘off-the-run’ credit index contract is likely to be significantly less liquid than the ‘on-the-run’ equivalent. And, even for an on-the-run index, the five-year maturity will be liquid where, say, the four-year is not. Changes in liquidity levels could also reflect external factors, such as weakening in the supply of credit. For this reason, it is important that the market infrastructure is sufficiently flexible to accommodate any change in liquidity.

In addition, given the potential for liquidity to change, liquidity triggers should also typically be two-way, i.e. the trigger should not only define when a particular regulatory provision applies, but should also define when the provision ceases to apply. Ideally, it should be possible to suspend particular obligations immediately, to ensure that markets continue to function (albeit with less turnover) during times when liquidity is stressed.

It has long been our view that legislative reform should support liquidity in the interest of systemic resilience, should protect the funding requirements of corporates and sovereigns and should advance the principle of strong risk management. And to that end, we support linking obligations to liquidity in appropriate circumstances. However, liquidity triggers:

• Must consider the various factors that collectively constitute liquidity;
• Must be forward-looking;
• Must be two-way so that obligations can be disapplied when necessary.

There are many welcome and positive developments in the Compromise Text. However, where the European Securities and Markets Authority (ESMA) is given the task of determining or applying a liquidity trigger, then its mandate should be such as to allow it to consider all relevant factors.

Honey, I Shrunk the Market

The OTC derivatives market knows that 2012 will be a transformational year for the industry. By year-end, the industry has to meet the challenging objective, laid out by the G-20, of trading all “standardized” derivatives transactions on electronic platforms, where appropriate, and clearing them through central counterparties (CCPs).

Increasingly, this task is looking extremely ambitious. ISDA made its views known in a letter to the European rule-making bodies. Market participants and regulators need time to think through the issues and prepare solutions to the challenges posed. Rushing through them can only lead to increased risks and unintended consequences. 

We have written before on some of these issues. Many of them emanate from the fact the supervisors are attempting to regulate a global marketplace with a series of “national” or “jurisdictional” regulatory initiatives – Dodd-Frank in the US, EMIR and MiFID in Europe, as well as other initiatives elsewhere (Japan, Canada, Hong Kong, Korea, Australia and others).

The OTC derivatives market, however, is perhaps the clearest example of a global market that has emerged over the past three decades. Unlike most of the underlying “cash markets” – which have grown locally and have been in existence for decades if not for centuries – the youth of the OTC derivatives market has enabled it to build its international foundations from the beginning. The ISDA Master Agreement is used by almost all participants to document transactions ubiquitously, and is perhaps one of the few – if not the only – document with global acceptance and application. Most OTC derivative trading books are global, feeding on demand and supply of client flows from all over the world. The integrated technology they use allows them to “see” and manage the same book as it passes through time zones and locations. Most banks that deal in OTC derivatives typically have a single global back-office where all the transactions, occurring around the world, are processed. The industry has built single data repositories where virtually all worldwide OTC derivatives transactions are captured by product.

Attempting to shrink this global industry and make it fit “national” or “jurisdictional” definitions presents a monumental task and an equally monumental risk. It gives rise to a myriad of risk management, operational, legal and technological issues that the industry and the regulators are only beginning to come to grips with.

An example from the US dollar interest rate swaps (IRS) market helps illustrate some of the issues that arise. It is well known that Fannie Mae and Freddie Mac are massive receivers of fixed rate IRS to compensate for the prepayment risk that exists in the large mortgage portfolios that they hold. This risk, to a large extent, is offset by European or Japanese corporate hedgers (in addition to the US), which are typically fixed rate payers. Attempting to clear such transactions can potentially lead to massively unbalanced positions in the respective CCPs, resulting in (and creating) a bifurcation of risk (in an otherwise risk-neutral position) and the need to post potentially different (and incremental) amounts of initial margins. Similar examples can be drawn from the CDS, commodities and equities OTC derivatives markets.

Worse, these “national” or “jurisdictional” regulatory initiatives are incompatible both in content and in the timeframe in which they are being rolled out. The CFTC in the US has a head start, having issued a number of rulings, but even that Commission is behind its own stated schedule. The SEC is further behind in its rulemaking, although it is supposed to work jointly in some cases with the CFTC. The situation is even more challenging in Europe where EMIR (the European equivalent of Dodd-Frank regarding clearing) is just now being finalized. ESMA – which is supposed to follow with its own rules – has not started the process either. And this is on clearing alone. The introduction of electronic trading platforms is likely to be another transforming event for the industry’s structure, the effects of which are only beginning to be discussed.

And while all this is happening, the end-2012 deadline is casting its shadow. There is increasing realization that there is simply not enough time to deal with all these issues. And if things are rushed so that deadlines are met, the likelihood increases substantially that mistakes will be made, risks will be overlooked, or simply that ill-conceived rules will be put in place with unintended consequences.