Transparency may be hazardous to your health

Esma should fine-tune Mifid II disclosure rules before they wreck markets

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It is treated as a truism in some policy-making circles that imposing transparency on opaque financial markets will bring them out of the Dark Ages and make them fairer for all participants.

Unfortunately, that's not always true. Consider the situation developing in the European Union, where bank commodity desks are wrestling with controversial transparency requirements arising from the revamped Markets in Financial Instruments Directive (Mifid II).

When Mifid II takes effect in January 2018, banks are likely to be classified as ‘systematic internalisers' (SIs) in over-the-counter derivatives markets where they act as market-makers. If so, they will face troublesome rules on both the pre-trade and post-trade sides. For many types of instruments, SIs will not be able to execute a bilateral trade with one client without broadcasting an actionable quote to all of their clients first. Then, after execution, they will need to disclose the price and size of the trade.

These rules have far-reaching implications for illiquid markets, including in many of the OTC commodity derivatives where banks still play a major role. The quote-broadcasting rule, for instance, effectively means bank commodity desks must build technology to flash quotes to their entire client base – something that would be infeasible if the bankers simply communicated to clients via phone or instant message. This is part of the reason why banks such as Goldman Sachs, JP Morgan and Societe Generale (SG) have been adding OTC energy derivatives to their single-dealer platforms in recent months.

The quote-broadcasting rule might also lead to pernicious situations in which banks post quotes on their electronic platforms, with the idea that a particular client will hit the bid or lift the offer, only to find that a speedy algorithmic trader has jumped in before any real-world client, such as an oil producer or airline, has had a chance to execute. "High-frequency traders that can execute faster than a blink of an eye might make it almost impossible for a corporate to execute a hedge with us," warns SG's London-based global head of commodities, Jonathan Whitehead.

Mandatory post-trade disclosures also pose a threat. That's because dealers, upon executing a trade for a client, generally turn around and lay off their risk as quickly as possible. In liquid markets this is easy enough. In illiquid markets it takes longer, and if details of the original client trade are posted before the dealer can hedge itself, opportunistic traders can jump in and move the market against the dealer. In the US, similar post-trade disclosures mandated by the Dodd-Frank Act have proved controversial. End-users such as Texas-based Southwest Airlines, which hedges in the thinly traded market for long-dated oil derivatives, say they ultimately bear the cost of the rule.

Luckily, European regulators have ways to soften the impact of the Mifid II transparency rules. For starters, the rules only apply to contracts deemed liquid by the European Securities and Markets Authority (Esma). They also only cover trades whose sizes fall below the so-called ‘large in scale' (LIS) and ‘size specific to the instrument' (SSTI) thresholds; trades above those levels are exempt from the quote-broadcasting rule and qualify for delayed post-trade disclosures.

So, problem solved? Unfortunately, no. Esma made an embarrassing mess of its initial study of liquidity in OTC markets. There is also a lively debate under way about the appropriate level of the LIS and SSTI thresholds. In March, the European Commission asked Esma to adopt a phased approach to SSTI, raising it gradually over the first four years.

That's a good first step. But EU regulators need to think hard about how to calibrate the rules properly, or else transparency might prove fatal to some markets.

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