With all the discussion about Dodd-Frank, Volcker Rule, Basel III and EMIR, it’s easy to forget the last piece of the puzzle, Europe’s Markets in Financial Instruments Directive 2, Europe’s Markets in Financial Instruments Regulation, and Regulatory Technical Standards, hereafter known as MiFID II, MIFIR and the attendant RTSs. ESMA has been hard at work drafting all of these, and on February 19^th it held an open meeting to discuss MiFIR, the MiFIR consultation paper (CP) and RTSs.

One of the most important, and contentious, aspects of these regulations has to do with pre-trade and post-trade transparency for non-equities. Earlier versions of MiFID applied mostly to equities and certain equity-based products, but MiFID II/MiFIR apply to non-equity products, where transparency takes on quite a different cast.

Let’s begin with the definition of non-equity instruments in Article 8 of MiFIR, which is “bonds, structured finance products, emission allowances and derivatives.” One might have expected a better definition, such as “debt instruments, commodities, currencies and all derivatives based on them,” or perhaps “any instruments not equities or derivatives based on equities,” but the definition is what it is.

Pre-Trade Transparency

Now let’s see what MiFIR says about pre-trade transparency for these instruments. First, “Market operators and investment firms operating a trading venue shall make public current bid and offer prices and the depth of trading interests at those prices which are advertised through their systems for bonds, and structured finance products, emission allowances and derivatives traded on a trading venue. That requirement shall also apply to actionable indication of interests.”

So another definition is in order. According to MiFID II a market operator “means a person or persons who manages and/or operates the business of a regulated market and may be the regulated market itself.” I’m not sure whether that definition includes an OTC bond or derivatives dealer, but that is an important question, because OTC dealers do not routinely “make public current bid and offer prices” made in response to a request-for-quote (RFQ) and would certainly resist any such requirement. It does appear to include market-makers on an RFQ venue, which is at least as bad.

The CP has some additional language about pre-trade transparency relating to RFQ markets. “Regarding the definition of a request-for-quote system ESMA proposes to amend the definition as follows: ‘A trading system where a quote or quotes are published in response to a request for a quote submitted by one or more other members or participants. The quote is executable exclusively by the requesting member or market participant.’” (Emphasis added) Thus it would appear that while RFQ responses must be made public, they are only actionable by the requester. For everyone else, they would be indicative only. In the open meeting the point was made from the audience that, even in liquid markets, having RFQ responses made public would cause those spreads to approximately double.

Under waivers, in keeping with the end-user exemptions in the US, “That publication obligation does not apply to those derivative transactions of non-financial counterparties which are objectively measurable as reducing risks directly relating to the commercial activity or treasury financing activity of the non-financial counterparty or of that group.” And, “The transparency requirements referred to in paragraph 1 shall be calibrated for different types of trading systems, including order-book, quote-driven, hybrid, periodic auction trading and voice trading systems.” Finally, there are some exemptions:

“(a) orders that are large in scale compared with normal market size and orders held in an order management facility of the trading venue pending disclosure;

(b) actionable indications of interest in request-for-quote and voice trading systems that are above a size specific to the financial instrument, which would expose liquidity providers to undue risk and takes into account whether the relevant market participants are retail or wholesale investors;

(c) derivatives which are not subject to the trading obligation specified in Article 28 and other financial instruments for which there is not a liquid market.”

The meeting also had considerable discussion about how the large in scale (LIS) and size specific to the instrument (SSTI) thresholds would be determined, since those thresholds will impact both pre- and post-trade transparency. The most likely method is the same as the CFTC used to determine block sizes, which is the trade size that captures a specified portion (1/2 or 2/3) of the average daily turnover (ADT). The meeting discussion is reminiscent of the debate prior to the CFTC’s establishment of block thresholds.

Finally, the meeting spent a lot of time on the process of determining whether a market is liquid, which MiFIR defines as, “where there are ready and willing buyers and sellers on a continuous basis, and where the market is assessed in accordance with the following criteria, taking into consideration the specific market structures of the particular financial instrument or of the particular class of financial instruments:

(i) the average frequency and size of transactions over a range of market conditions, having regard to the nature and life cycle of products within the class of financial instrument;

(ii) the number and type of market participants, including the ratio of market participants to traded financial instruments in a particular product;

(iii) the average size of spreads, where available;”

What does the RTS say about pre-trade transparency? Not much: “For the purpose of Article 8 of Regulation (EU) No 600/2014, market operators and investment firms operating a trading venue shall, in accordance with the trading system they operate, make public information in respect of bonds, structured finance products, emission allowances and derivatives as specified in Annex I.” Then there is more about the waivers, but not much detail at all. I guess we’re supposed to stay tuned.

Post-Trade Transparency

Given the well-established, if cumbersome, requirement for trade reporting across all instruments, one might well ask, “What could be new in post-trade transparency?” MiFIR devotes two articles to post-trade. Article 10 says, in its entirety:

“1. Market operators and investment firms operating a trading venue shall make public the price, volume and time of the transactions executed in respect of bonds, structured finance products, emission allowances and derivatives traded on a trading venue. Market operators and investment firms operating a trading venue shall make details of all such transactions public as close to real-time as is technically possible.

2. Market operators and investment firms operating a trading venue shall give access, on reasonable commercial terms and on a non-discriminatory basis, to the arrangements they employ for making public the information under paragraph 1 to investment firms which are obliged to publish the details of their transactions in bonds, structured finance products, emission allowances and derivatives pursuant to Article 21.”

An audience member in the ESMA meeting asked if trades have to be reported to a trade repository (TR) in real time, what benefit was there to having the venue make the same trade data available at approximately the same time? The ESMA staff acknowledged the logical inconsistency without actually responding, but the unspoken reason was probably that, with both parties reporting to the TR and often assigning different UTIs, the venue’s reports may be the only reliable data for the foreseeable future.

Under the waiver category, MiFIR says that, “the competent authorities may authorise the deferred publication in respect of transactions that:

(a) are large in scale compared with the normal market size …; or

(b) are related to [an instrument] … for which there is not a liquid market;

(c) are above a size specific to that [instrument], which would expose liquidity providers to undue risk and takes into account whether the relevant market participants are retail or wholesale investors.”

So the important point here is that each national authority can determine the size threshold for delaying post-trade dissemination. One might expect that all EU national authorities would have the same thresholds, but I wouldn’t bet the ranch on it. One other requirement in MiFIR: “Market operators and investment firms operating a trading venue shall obtain the competent authority’s prior approval of proposed arrangements for deferred trade-publication, and shall clearly disclose those arrangements to market participants and the public. ESMA shall monitor the application of those arrangements for deferred trade-publication and shall submit an annual report to the Commission on how they are used in practice.”

The RTSs add a few additional points, such as, “The details and flags … shall be made public either by reference to each transaction or in a form aggregating the volume and price of all transactions in the same [instrument] taking place at the same price at the same time.” And, “Investment firms shall take all reasonable steps to ensure that the transaction is made public as a single transaction. For those purposes two matching trades entered at the same time and for the same price with a single party interposed shall be considered to be a single transaction.” In the ESMA meeting there was some discussion of packaged transactions, which have been a particular headache for the CFTC, with my assumption coming out of the discussion that they would be reported as one trade and not as separate components.

Sharpening the Focus

It is clear that the overall intent of MiFID II and MiFIR regarding transparency is to have pre-trade markets and trade reporting available to the investing public. But the non-equity markets are very different from equities. They are more dominated by professionals, have a more heterogeneous product set, and a much higher percentage of off-venue large trades. When ESMA and the EU in general set about applying what had been equity rules to a very different market, they ran into all sorts of complications. Throughout the meeting, the ESMA staff were writing furiously in their notebooks, and saying, “Thanks for the question, we’ll take that into consideration.” When it was over, perhaps the best we could say was that we still need more transparency into the formulation of the transparency rules.

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