Having recently been voted through the European Parliament, the clock is now ticking on the next phase of the Markets in Financial Instrument Directive (MiFID) II implementation process. The onus is now on the European Securities and Markets Authority (ESMA) to take these principles and turn them into detailed technical standards, telling the market exactly how the principles should be implemented in practice.
One of the seven key principles introduced by MiFID II is a trading obligation for derivatives that are, ’eligible for clearing under the European Market Infrastructure Regulation (EMIR) and are sufficiently liquid’. So, what exactly does ’sufficiently liquid’ mean?
It’s important to approach this question thoughtfully as the absence of crystal-clear definitions of what is required of market participants in order for them to comply with any given regulation can lead to confusion in the markets. The confusion over what constituted a spot and an FX forward, for example, caused some commotion at the onset of mandatory trade reporting under the European Market Infrastructure Regulation.
An obvious definition of liquidity may be based on volumes, such as the number of positions or trades in the market. This may seem simple, but realistically, who has enough visibility of trading in the market to be able to assess the volumes and to deem them ‘sufficiently liquid’? Such an approach would also require the establishment of mechanisms to advise the market on which derivatives cross the liquidity threshold and are therefore eligible for clearing.
When drafting the technical standards, ESMA may want to look at the way the market generally defines liquidity, i.e. by using the bid-offer spread, which gives an indication of the availability of a product from multiple sources in a neutral, multi-broker venue. Thus, when one broker steps away from making a market, the number of remaining brokers is sufficient to ensure that there is a market with narrow bid-offer spreads for different sizes of volume. However, one then needs to consider defining spread and volume size.
Contract tenor can play a part in a liquidity profile too and the technical standards will have to address the scenario of a derivative whose liquidity changes through its maturity profile. Some products, such as futures and options, may be traded very lightly for longer tenors and the vast majority of volume concentrated in the prevailing short-term? contract.
Government bonds, however, may be very actively traded in the longer part of the curve for some countries. Also, the concept of the most recently issued government bond in a particular tenor range being the most actively traded (so-called ‘on-the-run’ versus the less liquid ‘off-the-run’) needs to be considered.
Some products can be heavily traded during their early days but as the product approaches its expiration, liquidity all but dries up. This can happen in physical delivery commodities when many speculators step out to avoid delivery. Also, short-term government papers are a buy-and-hold security in the last few days / months of their lives.
This can become even more convoluted in credit markets as this depends on each individual issuer’s outstanding debt profile.
In the US, the Dodd-Frank Act took a different approach to this question. Dodd-Frank effectively leaves it to the market to decide whether or not a derivative is sufficiently liquid to be cleared. Under the act, if a Central Counterparty (CCP) begins clearing an instrument, then it is automatically considered to be ’sufficiently liquid’ and it must therefore be traded on an appropriately recognised exchange.
CCPs will generally accept standardised contracts and these tend to be traded very regularly. It’s fair to assume that these standardised derivatives are what the market deems to be ’sufficiently liquid.’
My advice to ESMA as it deliberates on how best to define a ‘sufficiently liquid market’ is that a little bit of careful consideration now could save a lot of commotion when the principles in MiFID II eventually go live. Often, the best way to define a liquid market (especially for clearing) is to let the participants decide. If it is a sufficiently commercially attractive market / instrument, then the volume will flock to it; it then automatically becomes liquid and there will inevitably be a demand to clear it.