Speech by David Lawton, Acting Director, Markets, FSA at the TradeTech Liquidity Conference, London on 26 April 2012
Introduction
EU policymakers, legislators and regulators have certainly been very busy formulating measures to strengthen confidence in the trading environment following my appearance on this podium last year.
We now have:
- a pan-European regime for the regulation of credit rating agencies in operation;
- a soon-to-be implemented pan-European regime for short selling;
- an agreed text on the regulation of OTC derivative contracts in line with G20 commitments; and
- negotiations well underway on revisions to the EU framework for securities market regulation and the market abuse regime.
So when I was asked to speak to you to today, there was clearly a rich set of regulatory topics I could haven chosen to focus on.
But, having looked at the programme, it is obvious that you are all preoccupied with liquidity – how to find it, how to deliver it to your customers, and where to trade – and how the current set of regulatory proposals may impact on this important concept.
I will start by setting out why liquidity matters to regulators and how we think about it.
I will then turn to discussing some of the trade-offs that policymakers are confronted with when considering how to strengthen confidence in the trading environment.
I will then round off my remarks by touching on some of the specific regulations currently on the table that will potentially have an impact on the trading and liquidity of financial instruments.
Importance of liquidity
Regulators often state that their objective is to ensure fair, resilient and efficient markets – encompassed within that is the notion of liquid markets.
A liquid market can be defined as one in which there are ready and willing buyers and sellers at all times. Or more narrowly, as a market where large trades can be executed quickly, at low cost, when you want.
Insufficient liquidity in financial instruments can lead to:
- issuers, including governments, not being assured of raising sufficient funds;
- investors being exposed to very wide spreads or, at worst, being locked in to their investments;
- corporate hedgers being exposed to increased costs; and
- market-makers being exposed to increased risks.
And we should not confuse genuine liquidity with the volume of trading turnover. There is also a danger, in already liquid markets, of quickly decreasing marginal benefits of additional liquidity. What we are after is transparent and resilient liquidity.
Liquidity can be encouraged by opening up competition in trading venues, mandating certain pre- and post-trade transparency data and issuer disclosures, permitting trading on own account, and promoting orderly trading.
Speculators and market makers are key contributors to the liquidity of many markets by putting up their capital in seeking to arbitrage differences in risk or time preferences.
Trade-offs facing policymakers
But liquidity is not an end in itself; rather, a contributor to the wider regulatory objectives I noted earlier.
And it is those wider objectives a policymaker needs to consider when designing rules to strengthen confidence in the trading environment. Getting the balance and trade-offs right is key.
For example, many would support the objective of enhancing trade transparency because of the benefits it can bring in terms of fostering competition between dealers, facilitating best execution and assisting in the valuation of financial instruments.
But it is also clear that equity-like pre-trade transparency requirements, in particular, have the potential to negatively impact on liquidity provision in fixed income and derivative markets, if not properly calibrated.
The academic literature on market microstructure theory also shows that increasing disclosure in the form of greater pre-trade or post-trade transparency may have ambiguous effects on liquidity as ‘informed’ traders, who often act as market makers, may react differently to ‘uninformed’ traders.
So, policymakers need to get the balance right between enhancing transparency and not damaging liquidity.
Policymakers are also concerned about the impact on orderly trading and market resilience that may arise if market participants rapidly withdraw from providing liquidity.
The response has been to contemplate banning certain market practices such as market operators using their own capital to trade and putting limits and obligations on High Frequency Trading (HFT) firms. But, it is not clear whether policymakers have fully considered the possible impact on liquidity provision from such measures.
Academic studies suggest that liquidity provision is more robust when market participants have a choice between trading models.
The UK government has been sponsoring research on the future of computer trading in financial markets. One of the research papers published in September last year found a broadly beneficial impact on liquidity, price formation and transaction costs but warned that HFT provided threats to market stability. Other research on FTSE 100 stocks has found that, around the scheduled release of US macroeconomic figures, HFT participants return to providing two-way prices far earlier than other market participants, lending support to the argument that HFT does not abandon the market at the sign of volatility. This just goes to show how important it is to determine the real impact on market stability and liquidity resilience from such participation.
Regulatory measures impacting on liquidity
I have set out how liquidity needs to be seen in the context of wider regulatory objectives. Let me now turn to some of the measures legislators and regulators have, or are proposing, to come up with that may impact on liquidity.
The first is the proposed creation in the Market in Financial Instruments Regulation (MiFIR) of a new type of trading venue, the organised trading facility (or OTF). This is one avenue through which Europe would meet the G20 commitment to bring standardised and sufficiently liquid OTC derivatives contracts into a more structured trading space.
The OTF also brings with it pre- and post-trade transparency requirements and a proposal to ban OTF operators from using their own capital.
We believe the introduction of this new type of venue category is a necessary part of the revised regulatory structure, and we support extending the scope of regulation – such as organisational requirements and access obligations – to some of the trading that currently takes place outside organised trading venues.
But, as regulators, we need to ask ourselves whether it is in the best interest of end users – such as investors and corporations – to go further and prohibit certain structures without considering explicitly the impact on liquidity.
For example, the ban on OTF operators using their own capital, if adopted, has the risk of damaging liquidity in bond and derivative markets.
The potential conflicts of interest when a firm is both an operator and a participant of a trading platform can be addressed by requiring OTF operators to apply rigorous conflicts management processes, as is proposed for MTFs.
A second important issue in MIFIR we need to reflect on is whether firms deploying algorithmic trading should be subject to continuous market-making obligations. We recognise that this proposal is motivated by a rational concern that, in times of crisis, algorithmic systems are likely to withdraw liquidity from the market.
But, on the other side, we need to consider the potential impact such market-making obligations might have on trading participants if the law prohibits them from stopping trading when they experience losses.
It may be that, in times of market stress, firms will ignore the market-making obligations and withdraw from trading. Alternatively, firms may decide to pull out of trading certain instruments or strategies, and the knock-on effect may be a reduction in liquidity across markets.
Either way, we are not convinced that this is desirable and more thought is needed on how to increase liquidity resilience without jeopardising market stability.
And while we are on the topic of market resilience, can I take this opportunity to remind you that from 1 May, the ESMA Guidelines on systems and controls in an automated trading environment come into effect. They represent best practice for trading venues and investment firms to comply with existing legislation for maintaining efficient, orderly and resilient trading, and are part of extensive work undertaken by ESMA in the area of micro-structural issues and highly automated trading.
A third area of changes that may impact liquidity are the G20 obligations to centrally clear and trade on organised markets OTC derivatives that are sufficiently standardised and liquid. In Europe, ESMA is working on technical standards which will be used to determine which OTC products will be subject to the mandatory clearing obligation. Two consultation papers have been published so far, with final standards required by September and national implementation from January 2013.
These standards will be based on: the level of standardisation; the volume of trading and liquidity; and, the availability of reliable pricing information for the product.
The FSA and HM Treasury will be consulting on implementation, but firms shouldn’t wait for this before starting to prepare.
MiFIR, still under negotiation, sets out a procedure for the determination of whether a derivative should be subject to the trade obligation. Again a key criterion is being deemed ‘sufficiently liquid’.
We’ll have to wait and see what the precise impact on liquidity in instruments meeting the trading and clearing obligations will be. It could be that the increased costs for users of central clearing will result in reduced market liquidity in some instruments as users decrease their hedging activity, or it could be that as more and more contracts become standardised, liquidity will increase.
A fourth area of change, is that of the application of rules across jurisdictions where it is important we do not segment and splinter hitherto more integrated markets.
The MiFIR proposals would only allow firms from outside the EU to solicit business in the EU where their home jurisdiction is deemed to have equivalent regulation and offers reciprocal access rights to all EU firms. This is a much higher access threshold than under the existing regime.
The proposals also require third country firms that wish to provide investment services to professional clients to do so through the establishment of a physical branch presence in the EU.
Given the global nature of activity carried out in the EU’s international financial centres, this restriction is potentially very harmful to market end-users that rely on non-EU firms on a daily basis for their funding and investment needs.
There has been some positive progress in the European Parliament. The recent ECON rapporteur’s report helpfully proposes amending the transitional provisions so that third country firms can continue to do business in the EU under existing national regimes until a year after an equivalence determination is made. The original Commission proposal, on the other hand, sets a hard, four-year transitional period. The report also proposes to clarify that a third country firm, when providing services to persons who are genuinely considered to be professional clients, can do so on a cross-border basis without having to establish a physical branch presence. But no changes have been proposed to the nature of the equivalence assessment or the reciprocity rights.
Looking the other way, out from the EU, we, together with other international regulators and industry representatives, have similar concerns with aspects of the draft Volker rule, which prohibits banks and their affiliates from engaging in bond trading for their own account. The rule also imposes itself on non-US banks with a US presence, that is, it is extraterritorial in its application.
A fifth area where liquidity and regulation interact is in the European Short Selling Regulation, where measures of liquidity are used to determine trigger levels for the temporary suspension of short selling or reporting of net short positions in sovereign debt. A share admitted to trading on a regulated market is considered to have a liquid market if it is traded daily, with a free float of not less than €500 million, and either the average daily number of transactions is not less than 500, or the average daily turnover is not less than €2 million. Under this definition, only 785 shares out of over 6,000 listed on the ESMA website, meet the definition. ESMA is therefore proposing three different trigger levels for non-liquid instruments. So here we see liquidity being defined in a certain way and being used as a means to capture various activities.
That completes my run-through of current regulatory proposals most relevant to the liquidity of markets.
Conclusion
So to summarise, liquidity is clearly an important element of a well-functioning market, but it is not a regulatory goal in itself.
Integrity, resiliency, efficiency and investor protection are the foremost regulatory goals that need to be considered when designing measures to enhance confidence in markets.
Negotiations among Member States and the EU institutions are well underway in the Council and Parliament on the Commission’s proposed MiFIR text. The Parliament has produced a draft report and amendments from MEPs are to be tabled by 10 May. The Council is also working to produce a compromise text in May. But we expect that negotiations will continue into the Cypriot Presidency. On EMIR, ESMA has published two consultation papers thus far on the technical implementing standards which will need to be finalised by September, ahead of national implementation from January 2013.
Trade-offs are inevitable, but judgements need to be taken on objective and empirical grounds.
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