MiFID II, Transparency and European Corporate Bond Markets


By Jim Rucker, Global Head of Operations Services, MarketAxess.
With the release of ESMA’s Consultation and Discussion Papers on MiFID II the industry is much closer to understanding what these far-reaching rules might look like once finalised, and the changes they are likely to entail for market participants.
A clear goal for European regulators is to increase pre-and post-trade transparency in fixed income markets. We have always supported post-trade transparency, which we believe has had a positive impact on the size and liquidity of the US corporate bond markets.
We see potential risks to liquidity, however, in introducing mandated pre-trade transparency for less liquid products such as corporate bonds.
What is liquidity?
A critical piece of the MiFID II regulation will depend on how liquidity is defined and measured. In the US we have conducted regular research, using data from FINRA’s TRACE consolidated tape, to analyse and quantify liquidity and trading costs in the US markets over time.
More recently, we have conducted a similar analysis to understand the key differences between the liquidity characteristics of the US and European markets.
We looked initially at three key measures:

  • Overall trading volumes
  • Turnover rates (defined as the total amount traded, divided by the volume outstanding for the bonds that traded)
  • And overall size of the markets

Trading volumes
We observed some interesting differences. According to Trax estimates1, total trading volume for Euro-denominated debt in 2013 was only $1 trillion, just a third of the $3 trillion traded last year in US dollar-denominated debt according to TRACE data (Fig. 1).

1Trax estimates it captures approximately 65% of all fixed income transaction reporting to the UK FCA. Estimates are based on this data sample.

Turnover rates
We also found that bond turnover for US dollar debt was approximately 60%, compared to just 41% for Euros. This means that US$-denominated bonds were trading about 1½ times more frequently than Euro-denominated bonds (Fig. 2).

As a point of comparison, prior to the financial crisis, turnover in the US corporate bond market was running at over 130%, meaning that each bond, on average, was both bought and sold more than 1.3 times per year (Fig. 3).

Corporate debt outstanding
A similar picture can be seen for the total debt outstanding in each region. In Europe, high-grade debt outstanding has increased just 20% in the last five years, from $2 trillion to $2.4 trillion. Yet, during the same period, US high-grade debt outstanding has almost doubled, from $2.7 trillion to over $4.5 trillion, according to FINRA (Fig. 4).

What does this mean for European markets?
In short, the US markets are larger and more liquid than the European markets. And we can make some assumptions about the reasons why.
The introduction of TRACE in the US in 2002 represented a new era of increased post-trade transparency for the credit markets, which helped to increase competition. Access to regular and consistent pricing data for US high-grade and high-yield corporate bonds has enabled a much broader group of participants to enter the market, resulting in tighter spreads, which has, we believe, been one of the key drivers for the larger, more liquid US market. Furthermore, the depth of market has made funding in dollars very attractive not just to American companies but to foreign issuers as well. All of these combined variables have created a robust and liquid market with a large investor base and strong new issuance, as indicated by the growth in US dollar-denominated bonds outstanding.
Transparency: achieving the right balance
The corporate bond markets are highly fragmented and the majority of bonds trade infrequently. As the chart below shows (Fig. 5), in the 13 months from 1 July 2013, 51,000 fixed income instruments traded in Europe. On a typical day, the majority of instruments – approximately 45,000 – didn’t trade at all. On average, approximately, 6,000 instruments traded once and only 300 instruments traded more than 10 times per day.

Source: Trax
Note: Scope includes fixed income instruments reported via Trax, where Trax reported at least a single trade during 1-Jul 2013 to 31-July 2014 1. Includes IG and HY Corporate bonds, Agencies & Supranationals, EM, ABS, & Munis; Excludes Government and Sovereign bonds 2. Average of sample is assumed to be typical

As our data demonstrates, we believe that increased post-trade transparency is good for the market. Conversely, given the level of fragmentation in the corporate bond markets, requiring an overly granular level of pre-trade transparency (such as public disclosure of individual responses to institutional RFQs for less liquid instruments, as is currently possible under MiFID II) is likely to harm critical market liquidity. This will result in worse execution prices and ultimately impact returns for European investors.
European regulators have a tough job ahead of them. Today’s European credit markets are much more complex and fragmented than the US markets were twelve years ago, when TRACE was first implemented. It is critical, however that the rules achieve the right balance. An appropriate level of post-trade transparency will promote competition and help boost liquidity in fixed income markets. Too much pre-trade transparency which is not sensitive to the nuances of the institutional fixed income market, however, will have the opposite effect and is likely to hinder the growth of markets that are critical to the long term health of European economies.