Regulations have become very prescriptive in dictating whether dealers can commit capital to trading and, in MiFID II’s case, how orders are allowed to be handled.
In our “Bid This Bond” series, we are discussing how Basel III, MiFID II, EMIR, Dodd-Frank, the Volcker provision and a host of other mandates are adding more steps and validation points to the sales-trader and trader’s workflow. In Part II of the series we looked at how new innovations in quantitative evaluation techniques, like Bloomberg’s Liquidity Analysis (LQA) are now enabling firms to practically implement the detailed requirements underpinning these regulations.
In Part III we turn our attention to the specific effects of MiFID II on the fixed income sales-trader and trader’s workflow.
MiFID II – Prescribing “How to Trade”
Scenario 1: You can trade as a principal
Let’s assume that the bond in question has a Bloomberg liquidity score on LQA that matches the firm’s internal policies for being placed in category 1 or 2, that the Time To Liquidation (TTL) estimates place it in the trader’s inventory liquidity bucket 2 and that there is room in that bucket to commit capital (see processes and categories described in “Bid this Bond” Part II).
Since the bond has cleared internal policies, the trader can provide an OTC price to the client and execute the trade…. Not so fast. The prescriptive nature of MiFID II will require additional steps and validations in the workflow beginning in 2018, when the regulation is implemented (see Figure 1).
The first question the trader will have to answer under MiFID II is whether the bond is sufficiently liquid that it will have to trade on a venue. ESMA makes that determination and is expected to publish guidelines that traders will have to check to see if they can simply provide an OTC price or if they need to trade the instrument on a venue.
Although the exact implementation details of the regulation (the “delegated acts”) is still pending, under the current principals of MiFID II, if the firm’s market making activity in the specific bond sector is significant and frequent then it can’t be a simple OTC trade anymore and the firm needs to operate a venue (called a Systematic Internalizer or SI) in order to complete capital commitment customer trades. If the firm’s presence in the bond is small and infrequent, then the trader can provide an OTC price to the client.
Operating an SI carries with it regulatory operational transparency and best execution obligations. Some firms may not want to operate such a venue because of these additional regulatory obligations.
In our example, if ESMA deems that XYZ’s of ’46 is liquid AND if the firm in that instrument has both a significant market share in trading the bond and they trade the bond frequently then the firm will have to register as a Systematic Internalizer (SI) venue in order to facilitate the trade with the client.
A firm that isn’t operating an SI has to check, “Will the order potentially cause me to become an SI (and I don’t want to become one)”? If the inquiry does, then the trader has to complete the inquiry acting in another capacity rather than dealer. However, if the firm operates an SI, then the trader can provide the client with a price (we discussed what “price” means in Part II).
New transparency obligations
In any case, when providing a price under MiFID II, either in the capacity as OTC dealer or a SI, there will be transparency obligations. The larger the order, the more reluctant a trader or institution may be to provide a tight price if they do not foresee that they will have sufficient time to hedge before disclosing information to the public under the new transparency requirements. The trader needs to determine if the order is eligible for a transparency waiver as well as assess the balance or trade-off between providing liquidity, prices and transparency. In consideration of this trade-off, ESMA will set waivers where transparency can be delayed.
Of course, size and transparency are factors in the price formation but for the purposes of the workflow, the size waiver determines whether or not pre-trade price provided to the client has to be made public through an Approved Publication Arrangement (APA). Bloomberg is anticipating becoming an APA and with this mechanism will be able to provide clients of the APA with the information needed to help them in systematic internalizer determination.
If the inquiry is eligible for a waiver, then after a compliance check the price can be relayed to the client. After the trade is completed, the Bloomberg’s APA will have functionality to hold the release of the completed trade as per ESMA’s time waiver guidelines.
If the inquiry is not eligible for a waiver, then after a compliance check the price is relayed to the client and to the APA simultaneously. When the trade is completed, the trade price has to be conveyed to the APA.
Scenario 2: You have to trade as an agent or riskless principal
That happens if the bond doesn’t meet internal criteria for capital commitment, or the firm doesn’t want to do the trade because they don’t want to become an SI? Then the firm has to act in a different capacity to service the client (Figure 2). In this case, the sales-trader can act as an agent working the order on a venue – such as a Regulated Market (RM) or Multilateral Trading Facility (MTF). Or, the sales-trader can shop the order to find the other side and operate as riskless principal or matched principal. If the firm does not operate a SI, then they can operate an Organized Trading Facility (OTF) where customer only orders interact, supervised by traders or sales traders.
As you can see from this work flow and the ones we discussed in parts 1 and 2 of this series, regulation continues to be more complex and prescriptive in dictating whether dealers can commit capital. MiFID II adds yet another dimension and layer in how orders are handled within financial institutions. In today’s regulatory environment, the availability of key data points like capital charges, liquidity metrics, trading venue and transparency requirements are not only key for firms looking to implement best practices, but they are critical for firms to continue to remain competitive in the capital markets.
