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.

The New York Fed Report, Hedging and Market-Making

Last week, derivatiViews commented on the New York Fed’s study on the CDS market. The study confirmed in many ways our own research and provided some important new data on market participants and their activity in the CDS market. We only wish we could see more OTC derivatives analyses from the New York Fed and other, well-regarded regulatory bodies. This week we address market-making and hedging, another topic covered in the report.

In Section X on Hedging in the New York Fed report, it was noted that when dealers executed large single-name CDS trades for customers, they did not engage in any offsetting trades on the same day 47% of the time. However, this was an average number and needed to be examined further. The report showed that for actively traded reference entities, same day hedging occurred 79% of the time. As might be expected for less liquid reference entities, there was less same day hedging – 55% of the time for less frequently traded entities and only 44% of the time for infrequently traded entities. And remember, there are only 10 trades a day in actively traded entities globally, four in less frequently traded entities and less than one trade per day in the infrequent entities.

Following this analysis of the market was a single statement in the Fed report:  “Our analysis seems to suggest that requiring same day reporting of CDS trading may not significantly disrupt same day hedging activity, since little such activity occurs in the same instrument.”

Some, though not all, commentators pounced on the statement, concluding same day reporting for large trades was the way to go. We were surprised at this. Indeed, we are still surprised. But one of ISDA’s responsibilities is education so we will educate.

For one, commentators may not have read the next sentence. It urged policymakers to gauge what impact greater post-trading transparency would have on dealers as dealers’ current hedging approach facilitates trading in the CDS market. Nor might they have understood the statement in the Executive Summary: “The low trade frequency of most CDS… combined with relatively large trade sizes highlights the important liquidity providing role of the market maker…”

So we thought we’d go back to square one and talk about market-making. We’ll start with a government bond desk. Say a client asks for a bid for an off-the-run 15-year Treasury bond. A bid is given and the dealer buys the bond. Does the dealer immediately try to sell the bond? Probably not. Suppose, just as it has purchased the 15-year bonds, it sells a 10-year Treasury note to another client and has thereby hedged its exposure to interest rate movements. The dealer may carry both the long and short positions on its balance sheet and will only unload the positions if it is concerned about curve risk, balance sheet usage or financing availability. Naturally, the dealer’s best outcome is to sell the 15-year bonds to one client and buy the 10-year notes back from another. But the willingness to hold positions explains why dealers carry billions of dollars of government bond inventory.

A similar process occurs for corporate bonds and CDS. Dealers have single name, industry and rating limits for credit product as well as aged inventory policies. Dealers are meant to facilitate client business. They have merchandise for sale – inventory purchased from clients – and add to that inventory when clients trade with them. It is no secret that, after providing liquidity to a client, a dealer may require a prolonged period to work out of the position.

Let’s look at an example of how this applies to a large CDS trade. Assume a dealer sells $20 million of protection on an infrequently traded reference entity, one of the 1,300 entities which the Fed has calculated trades less than once a day. What does it do? If the dealer immediately shows an interest in buying protection to brokers, other dealers will know it has a position. With less than one trade executed per day globally, the dealer needs to keep its position quiet. It may show a slight interest in one way or another to hedge part of the position but it must be careful or the market will trade against it. It may “hedge” its position through an index trade but it will try to work out of the position over time unless, of course, it does not like the credit. Then, it buys protection at whatever price makes sense to it.

What does this say about same-day reporting for large single-name CDS? It does not mean the full size and price details should be revealed immediately or even with a delay. Perhaps a good start is the TRACE system. TRACE requires disclosure of corporate bond trades within 15 minutes of execution but trade size need not be disclosed if it exceeds $1 million. The corporate bond market is more active although it trades in smaller sizes per trade. It respects the role of market-making and has protected it to ensure clients can buy and sell securities at reasonable prices. TRACE is not perfect but we hope reporting regulations for CDS markets will provide comparable protection of market-making.

We hope our little class has been useful and thank the New York Fed for their analysis. We know of more than one regulator that still owes the marketplace a cost-benefit analysis or two.

CDS Unveiled: The NY Fed’s CDS Report

The Federal Reserve Bank of New York issued a paper on the CDS market this week that was quite thorough and professional. We found it interesting on several fronts – so much so that we’ll devote two derivatiViews posts to it. Today’s will focus on market size and we’ll agree with most of what the report reveals. We’ll try to show how market-making works and how dealers offset risk as well as the importance of reporting delays or incomplete trade reporting for large trades. (Readers should also know that our press colleagues have discussed briefly the media reaction to the report in our media.comment blog.)

The Fed paper examines three aspects of CDS market size: the frequency of transactions, the average size of transactions and finally the number of participants. We will focus on the single-name CDS market as that has clear analogies in the corporate bond market and it will keep our story short and sweet.

Regarding frequency of transactions, the report confirms what ISDA and other commentators have often said in the past. Single-name CDS do not trade very often. In fact, the report shows a total of 3,000 single-name trades a day – both corporate and sovereigns. This global volume compares with volumes in the US corporate bond market alone (which excludes the large Eurobond market) that are five or more times as large. Over a 12-hour trading day, single-name CDS trade only 250 per hour. Apparently, CDS traders do not do very much trading.

But that’s not all. The report divides the 1,554 reference entities that traded during the three-month study period into three categories: the top 48 “actively traded” reference entities; the next 219 “less actively traded entities; and the last 1,287 “infrequently traded” entities. How much do each of these entities trade each day? The answer is: not much. The actively traded names trade only 10 times on average. Less actively traded entities trade only four times per day while the largest category by far, the infrequently traded entities, trade on average less than one time per day. Each of these figures confirms another fact about the CDS market. Not only is the market small in the aggregate but it is small with respect to every single name as well.

The report also contains useful information about transaction size. In the single-name market, the average size trade for corporate CDS denominated in US dollars is $6.7 million and for euro-denominated CDS it’s €5.9 million. Sovereign average size is larger – $16.7 million and €12.5 million. Five percent of US dollar corporate trades are $20 million or higher while the same figure for sovereign CDS is $50 million and €50 million. We do not have comparable figures for the US corporate bond market but knowledgeable participants have assured us $20 million trades do not make up 5% of the market. These figures point out what other studies have shown. The CDS market is a wholesale market designed for large players.

Finally, the last characteristic of market size is the number of participants. Here we disagree with some of the comments in the report, but are grateful for the data the NY Fed compiled. The report finds a “broad level of participation in the CDS markets” and cites as evidence the fact that there are 50 to 100 unique market participants trading daily in single-name CDS. We recognize the report uses the word “broad” in a number of ways, but how can 50 to 100 participants be categorized as broad? In the entire three-month trading period, there were only 993 unique market participants and this includes players in the credit indices market. Changing terminology slightly, the report states that 500 participants trade corporate CDS at least once a month. Forgive us for scratching our head when these levels of participation are described as “broad.”

Taken together, the market data in the report confirm a description of the CDS market we have long espoused. CDS buyers and sellers are few in number, execute a small number of trades, and prefer those trades to be larger-sized transactions. The CDS market requires strong market-making. Participants use the market because it works and offers the size, price and certainty of execution the cash markets cannot provide. We will pick this up next week and discuss market-making.