It’s February 2022. MiFID II legislation has been in force for five years. Five years which have reshaped our financial market structure. How does the market look? The last five years have seen the markets become less diverse. There are very few small participants in the markets: the regulatory burden has led them to merge with other, larger participants, or driven them out of Europe all together. Some of them trade just OTC so we don’t see the effects of their participation. On the lit markets, the reduction in the number of market participants, and orders, means that there are fewer market makers providing liquidity, risks are higher so spreads are wider. This makes it harder for end customers to get a good price on the lit markets: leading to institutions moving their business away from the centralised marketplace and towards internalization. Tick sizes have widened for the majority of liquid share symbols, and this has also helped to push orders away from lit markets. It’s been a steady downward spiral movement, and it’s still going. We’re all wondering how we failed to spot this risk in February 2015.
This brings me back to today. It is important to me, as it is to all market participants, that what we build today in MiFID II creates stronger, sustainable markets, and doesn’t lead us to look back on today and wonder how we could have been so short-sighted.
My concern is with liquidity in the lit markets: my feeling is that the current draft regulation goes too far in places, running the risk that the regulators of today may be paving the way towards dysfunctional markets in 2022.
First let’s remind ourselves what liquidity is. The liquidity of any product depends on how easy or hard it is to buy /sell an asset quickly without affecting its price. In other words it’s dependent on the number and quality of those market participants who share their prices, order sizes, and update behavior with other participants. Therefore the presence of liquidity is related to the quality and quantity of information available. Transparency is central to liquidity: there may be institutions to trade with in a dark pool, but you can’t guarantee the liquidity as you don’t get publicly reported orders and prices for each product (stock, bond, future, options, ETF). Without the transparency to see the whole ecosystem of the market, bid-ask spreads widen because those providing them cannot see the factors influencing the prices around them (number of orders, order size, etc.).
The number of market participants is key to good liquidity: we need enough competing participants of each and every discipline (i.e. market makers, institutional investors, investment banks) to keep the prices accurate, ensure efficient transfer of risk, and keep the spreads tight.
Smaller firms often provide passive liquidity supply, as opposed to the higher risk strategy of formal liquidity provision, but it is likely under MiFID II that they will now be compelled to provide liquidity on a formal basis, which many cannot afford. As a result, this source of liquidity will be lost to the markets.
A further threat to small firms under the new regulatory regime comes in the form of capital requirements and compliance costs. With proposed requirements such as full time dedicated compliance officers, duplicate hardware lines, and full business continuity back-up facilities, the burden on small market participants would be disproportionate and potentially destructive. Smaller market participants may struggle to maintain a viable business in Europe under these pressures and choose, instead, to exit the European market.
In a similar vein, there are concerns that the MiFID II proposals around Order to Trade Ratios will restrict competition between venues. The proposals fail to consider the impact of OTRs on a new trading venue: new platforms are only able to start business by quoting prices without trades as there will not yet be the liquidity to fill them. If OTRs come into force, fewer participants will be able to afford to add liquidity to new markets by starting to quote there.
There is also a potential risk that under MiFID II the number of clearing houses will decrease, meaning less choice for consumers. Banks once committed themselves to clear business for market participants, but because of the increase in capital requirements to do this, some banks have ceased clearing, and those still doing so are under pressure. With fewer clearing houses in the markets the risks are concentrated in the few still operating: creating a ticking time bomb.
Dark pools also provide competition to the central markets: they’re good for executing large institutional orders without moving markets, but they were intended as a supplementary trading venue to the centralized markets and must remain that way. The proposals to increase tick sizes will only serve to drive business into the dark: by forcing spreads to widen it will become easier for systematic internalisers and dark pools to improve on price. If too much business is transacted in the dark, market makers will not receive enough information to quote accurately: spreads will widen further and liquidity will drop.
Central markets are the main driver of a well-functioning economy, in which risk transfer can take place in an efficient and transparent way, but proposed regulation risks driving the markets to internalization and order crossing, which could have severe consequences.
This brings us back to where we started, looking in 2022 at a reduction in the number of participants and technological innovation, leading to wider spreads, more internalized business and fewer market makers: an interminable downward spiral away from a liquid centralized marketplace. This outcome would run contrary to MiFID II’s original endeavour to ensure trading across all asset classes occurred as much as possible in open and transparent markets.
In a scientific experiment it is customary to change a single variable at a time, to conclusively prove the relationship of cause and effect between change of input and change of outcome. While we can all appreciate that to do so with the markets would be impractical, so many changes are being made through MiFID II that it seems impossible that we will be able to look back and accurately determine which elements of the legislation proved to be good or bad. We will only have a single litmus test: have we preserved liquidity in our markets or not? This is the responsibility held by all our regulators today, not just ‘the market’, and we will all look to see the results in 2022.
For more information on the types of market participant and the structure of today’s markets, click here.
First published by FOW.com, 9th March 2015.