Recital 46, MiFID, gives the faculty to member states to broaden the transparency regime to financial instruments other than shares. Only two member states have exercised this option and extended this regime to bond markets (Italy and Sweden).
There are two main reasons why this option has not been widely exercised: i) non-equity markets81 have a different market microstructure from equity markets and trading mechanisms are designed to enhance resilience in case of liquidity issues; ii) A general possibility to opt in may not give enough incentives for member states to exercise the option, thereby pushing them to behave strategically. In effect, the latter represents a typical prisoner’s dilemma. Member states have no incentives to ‘behave cooperatively’. If they deviate from their current application of MiFID, they may put their markets at a disadvantage, in particular if they impose stricter requirements for non-equity instruments.
Recital 46
Non-equity markets, moreover, have different trading mechanisms. Trades are typically dealt with a quote-driven dealer system or bilateral negotiations with the support of an intermediary. Most transactions are arranged via a dealer. Trading can be continuous or periodic and dealers typically have an informational advantage over investors as intermediaries. Accordingly, market-makers move first and propose price schedules. Therefore, equilibrium may be found in dealer markets (with one specialist or
Dealer markets
81 CESR (2010f) has defined as non-equity financial instruments: a) corporate bonds; b) structured finance products (Asset Backed Securities and Collateralised Debt Obligations); c) Credit Default Swaps; d) Interest rate derivatives; e) Equity derivatives; f) Foreign exchange derivatives; g) Commodity derivatives. Other non-equity financial instruments that should be considered are sovereign and local authorities bonds, and equity-like instruments.
competing market-makers), since they are more resilient and efficient as long as the market is not too big and the information asymmetry not too large (Glosten, 1989; O’Hara, 1995). Dealer markets are hence designed to deal with less-liquid markets, only if this ‘low liquidity condition’ is verified. Dealer markets, in general, can:
1) Provide stronger protection against exposure risks (Pagano-Roell, 1993);
2) Reduce information leakage;
3) Reduce costs for uninformed traders (if they have contractual power due to the market illiquidity or competition in the dealer market); and
4) Better price if dealers can exploit private information and investors can control their fair use (Madhavan, 1995).
There are other two specific reasons why most non-equity products, even less complex ones, are currently traded in quote-driven markets, with a strong dealership:
i) Structure of the demand; and
ii) Structure of the intermediation.
Firstly, demand for such products comes mainly from institutional investors and other dealers, since retail participation remains highly costly in terms of cost and lack of sufficient knowledge. The nature of clients, and the complexity, heterogeneity and large size of non-equity financial instruments affect market structure and thus the prices of financial instruments. In dealer markets, institutional investors can exploit their contractual power and customise their transactions more than in a non-discriminatory and open market setting (Biais & Green, 2007). Moreover, dealers can have more control of their risk positions when they deal with few market operators and exposures.
Secondly, the structure of the intermediation favours certain market developments. In effect, the amount of capital committed to intermediation by dealers may affect per se the choice of a specific level of transparency. If dealers act as a principal in the transaction, on the one hand, there is more chance to create a market for illiquid products by selling them direct to investors, but – on the other hand – financial products will sit on dealers’ balance sheets, with inventory positions that need some protection from market impact through less public disclosure, in order to be still able to act as intermediary. Then, if dealers only act as broker-agents, on the one side, there will be less capital committed and thus less need for protection from market impact and more public disclosure. But, on the other side, illiquid products may not receive execution due to insufficient demand. The complex nature of modern financial markets and economies requires intermediaries to provide clients with more tailored and sophisticated products and services, which may often be traded only in specific market settings and with limited public disclosure. The use of electronic multi-dealer platforms has surely increased competition between dealers, who compete with executable quotes, and extended market accessibility to a wider set of investors who qualify as ‘members’ (typically only brokers or institutional investors). A strong push towards pre-trade public disclosure may require a rethinking of current market structure and intermediation of less-liquid asset classes (such as some categories of bonds, OTC derivatives and structured products), which may anyway lack price transparency since they are typically based on proprietary valuation models
(CESR, 2009).
Greater pre-trade transparency can indeed reduce search costs and enhance price discovery processes as long as all relevant investors can easily access these markets and dealers are not damaged by information revelation. Flood et al. (1999) found that in a dealer market opening spreads would be wider and trading volume lower, but price discovery should be faster since traders would behave more aggressively in order to find liquidity. Other authors therefore find a negative trade-off between liquidity and price efficiency if transparency varies. Bloomfield and O’Hara (1999) did not find any relevant impact of pre-trade transparency requirements on dealer markets. Greater transparency, on the one side, may reduce the informational advantage that dealers exploit in exchange for the provision of liquidity and introduce uncertainty in bilateral negotiations. The nature of the counterparty, for instance, is usually included in the calculation of the price offered by dealers, which cannot usually be estimated without an explicit request from the client. On the other hand, however, the absence of pre-trade information may keep the price discovery process for non-equity products very costly and therefore inefficient, and it may promote a market setting with low competition.
For all these reasons, a pre-trade transparency regime for non-equity financial instruments should be designed in a different way from auction order-driven markets or quote-driven dealer markets (duly adapted and proportionate). In this regard, MiFID pre-trade transparency requirements cannot be transposed as they now stand in order to prevent unintended consequences on the incentives of dealers to provide liquidity through the use of private information. In effect, pre-trade transparency may improve search liquidity, since pre-trade information is asset-specific and helps to reduce search costs and uncertainty around them, even in dealer markets (Laganá et al., 2006). However, a pre-trade transparency regime could be effective, depending on the number of potential counterparties that can offer that tailored product and on the level of exposure of dealers’ inventory positions to the market, since trade size is typically far higher than the retail one. This leads dealers to offer executable quotes only on electronic platforms where liquidity is selected and accessible to members meeting certain requirements. On platforms where traded products are commonly accessed by retail investors, it would be easier to implement general pre-trade transparency requirements as long as the demand is very high, which may not be the case for complex non- equity products. Current market microstructure makes public disclosure of executable quotes difficult and costly (Biais et al., 2006). Also, many non-equity products are highly customised, so pre-trade transparency might be of little help. The greater concern is liquidity, which is to find a dealer that can tailor a transaction around the client’s needs. If transparency requirements reduce market makers’ returns, they may ultimately confine their activities to those products that are inherently more liquid, exiting markets for less-liquid ones. Pre-trade transparency for complex non-equity products could only work by changing the way how these instruments are actually traded towards open limit order books. To achieve this, the nature of the demand needs to be constant and sufficiently high over time.
Benefits and costs
The Commission (2010b, p. 28) has finally proposed that investment firms willing to quote or receive a request for quote (RFQ, probably run on organised trading facilities) would be requested to publish price and volume available to
the public, and eventually commit to it for sizes below a certain threshold (retail size). The threshold will be specified per asset class.
Conclusion # 5
A strong push towards more pre-trade public disclosure would require, in some cases, a rethink of the current market structure for less-liquid asset classes, and a shift from its mainly institutional demand to a more retail and smaller professional one. Conflicting views in this area emerge around what should be the most efficient market structure for these products. Liquidity in non-equity markets, such as markets for bonds, derivatives and structured products, is currently handled through quote-driven auction markets, inter-dealer platforms or bilateral negotiations led by dealers’ capital commitment. For auction markets, whether led by dealers/market-makers (quote-driven) or directly by demand (order-driven), pre-trade transparency is urgently needed. For inter-dealer platforms (request-for-quotes model) or bilateral negotiations, where dealers commit capital by being non-neutral counterparty, less pre-trade transparency than order-driven ones (e.g. equity) is needed to function properly. Executable prices might thus not always be consistently available. The alternative to a shift in market structure and in demand, which may not necessarily occur, is to design a different transparency regime from the one applied to equities. In general, pre- trade transparency may not be of any help to the market if it does not serve price discovery of investors. For markets in which the demand is more retail-driven, the need to have greater pre-trade transparency will be higher as it will noticeably reduce search costs. However, an appropriate level of pre-trade transparency may be beneficial for non-auction markets as well, as it may reduce investors’ search costs and promote greater competition between dealers. Some market participants consider that currently available pre-trade data is sufficient and legal requirements are not needed, since non-equity markets do not necessarily function as equity markets and current transparency have not limited participation to these markets.82 Others instead (and CESR, 2010f) believe, however, that an ad hoc pre-trade transparency regime (with waivers) should apply for non-equity products (in particular, bonds) listed on RMs or MTFs. Access to this information should be made easier for retail investors.
Conflicting views also emerge as to how to design the transparency regime. Many believe that preference should be given to the nature of the market rather than the nature of investors (retail versus wholesale). For financial instruments mainly traded over-the-counter on a bilateral basis, the introduction of any pre-trade transparency regime must prioritise the avoidance of adverse liquidity consequences for involved counterparties and systemic risk.