MEMO
Updated
MiFID/MiFIR, level 2: Liquidity and size specific to the
instrument for bonds
Date
Liquidity
21 November 2014
Only true liquid instrument should be considered as such
When introducing new rules on liquid instruments, proper calibration of liquidity is a key factor in ensuring efficient markets. If a financial instrument
is wrongly deemed as liquid, liquidity providers trading the particular instrument will be forced to comply with enhanced transparency rules compared to illiquid instruments and maybe an obligation to provide firm
quotes. As a result of these rules, the liquidity providers will be exposed to
undue risk and will most likely refrain from trading the instrument going
forward resulting in even less liquidity than before. If the rules imply that
illiquid bonds are deemed liquid, it will compromise the Commission’s ambitions to building an efficient Capital Markets Union, where e.g. corporate
bonds must play a significant role in increasing the depth of EU capital markets.
Step-wise approach is appropriate
Even for liquid instruments, the proposed transparency rules and quoting
obligations can be too extensive. Since the rules are comprehensive and farreaching, the consequences can be devastating for liquidity, issuers, investors and the real economy if introduced in one step (“big bang”). It would
worthwhile to introduce a stepwise approach1, carefully investigating the
impact of each step, before introducing the next step. It is far easier and
much more responsible to correct a wrong step in a stepwise approach than
to revitalise absent European bond markets which are dried out of liquidity
due to the new rules imposed at once. Also in the US, which is a much more
homogenous and developed market, it has been considered necessary to
introduce new transparency rules through a step-wise approach in the context of TRACE.
No coverage ratio
ESMA has not proposed any thresholds for the components and proposes
either professional expert judgement or a “coverage ratio”, i.e. x % of the
traded volume is deemed liquid. We strongly oppose the “coverage ratio”.
The “coverage ratio” is not appropriate since it will most likely result in illiquid instrument being deemed liquid. Relevant thresholds should be appropriately calibrated by professional experts.
1
The overall framework should be set from day 1 in order to ensure that markets can
rely on a robust, predictable and consistent set of rules.
Contact Helle Søby Thygesen
Direct +45 3370 1092
hst@dbmf.dk
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IBIA vs. COFIA
NSA recommends IBIA for bonds, alternatively COFIA IF adequate subclasses can be constructed and IF size specific to the instrument reflect retail size level for SI purpose. If COFIA is used for bonds without adequate
subclasses, it is likely that instruments will be labelled as false liquid with
detrimental consequences. At least the following subclasses should apply if
COFIA is chosen:


Homogeneous risk characteristics for each sub-class
Currency


Credit quality distinguisher
Open or closed for tap issuing
Recommendations for liquidity calibration

IBIA for bonds or COFIA IF adequate subclasses and IF size specific
to the instrument reflect retail size level for SI purposes.

No coverage ratio, the relevant threshold should be set by professional experts

Average frequency of transactions should be a combination of minimum number of transactions within a specific time period and the
minimum number of days on which at least one transaction occurred
(option 3).

Average size of transactions should be a combination of total turnover over a period divided by the number of transactions and the total turnover over a period divided with the number of trading days
during that period (new “option 3”).

Data related to market participants should be linked to the criterion
for liquid markets: ..”.. a market where there are ready and willing
buyers and sellers on a continuous basis.”. A number less than
#end-sellers AND #buyers active should imply an illiquid market in

that particular instrument
In concrete figures, the gross sample of potential liquid instrument
should as a minimum be based on a combination of scenario 5 and
6 in DP, table 15, page 127:
o
There should be at least 2400 trades during 1-year period
(10 trades a day with 20 trading days per month) per ISIN
o
The instrument should be traded at least on a daily basis
per ISIN
o
Based on the scenarios, the average daily volume should
be at least 10 mm EUR per ISIN. However, in order to ensure adequate volume, we suggest an average daily volume
should be at least 100 mm EUR.
An example of liquidity calibration
ESMA has proposed various components to be used in determining whether
an instrument is liquid. The NSA has identified a gross list with data from
NASDAQ (October 2013 - September 2014) with instruments (Danish mortgage bonds at ISIN level with an issue size more than 5 bn DKK) that could
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be relevant to consider based on their turnover and number of trades. The
Page 3
list (containing 135 ISINs) has been used to calculate the components
asked for by ESMA.
We observe the following:
File No 514/25

A considerable share of the ISINs has no or very limited activity

58 ISINs (43% of the sample) have more than a yearly turnover of
2.4 bn EUR

In a considerable share of the ISINs, the turnover is bunched together in connection with the time of issue.

Less than 10 % of the 58 ISINs have an average daily volume of at
least 100 mm EUR

Approximately 50 % of 135 ISINs have less than 200 trades per
month:
o
4 ISINs complies with the criteria above if average volume is
at least 100 mm EUR
o
26 ISINs complies with the criteria above if average volumes is at least 10 mm EUR
So it is not adequate just to take i.e. one parameter like the issue size into
account for liquidity calibration. It is crucial to investigate other, relevant
parameters as illustrated in the example to ensure that only true liquid instruments are deemed liquid.
Size Specific to the Instrument (SSTI)
The size specific to the Instrument (SSTI) serves several purposes:

It is the threshold (“upper limit”) for Systematic Internalisers’ (SI)

firm quotes
It serves as a waiver for liquidity providers and applies in request

for quote and voice trading systems
It serves as a threshold for post trade deferral (no requirement on
trading systems)
When determining the threshold, it is critical to take notice of MiFIR art. 9
(b) and 9 (5) (d) (ii) and thereby take into account whether liquidity providers are able to hedge their risks and where a market consist in part of retail
investors, the average value undertaken by retail investors. Retail order size
– either real or constructed – is key to use and not the normal market size,
since this size will be very large due to the wholesale characteristic of the
non-equities markets. SSTI should not be measured as a percentage of the
Large in Scale size (LIS) as suggested by ESMA since these have very different aims. In this context it is relevant to refer to the co-legislative process, where the European Parliament identified EUR 100.000 as the threshold for pre trade transparency. NSA supports a SSTI threshold of EUR
100.000, which is also equivalent to the minimum threshold in the prospectus directive.
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Differentiate between pre- and post SSTI?
Page 4
It could be considered to introduce diversified levels of SSTI depending on
whether it is aimed for pre- or post-trade since pre trade transparency risks
are greater than post trade transparency risks. SSTI for pre-trade purposes
should be the lowest threshold.
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The larger the SSTI, the larger the risk
Today, liquidity provider’s quotes are typically tailored for a specific client,
taking in a range of factors, rather than being a statement to the market.
This will change with the SI regime and the threshold for firm quotes (SSTI)
must reflect this change. If SSTI is higher than proposed by NSA, the market risk will increase and quickly become significant due to the exposure if
several clients utilise the firm quotes. For smaller countries with own currency, there is an additional currency risk since SIs often need to hedge in
e.g. German bund futures. Furthermore, if the SSTI is higher than the proposed amount there will be SIs’ who will have to refrain from taking on this
obligation due to the risk. The result is fewer SIs and lower liquidity. It has
been argued that the SI can say no to providing quotes. However, that is
not an option for SIs. If clients cannot count on the SI quotes, the SI will
face a considerable reputational risk which will negatively affect (other parts
of) the SI’s business.
Recommendations for size specific to the instrument

SSTI must reflect retail order sizes and should be set at EUR
100.000 which is also equivalent to the minimum threshold in the
prospectus directive

It can be considered to differentiate pre- and post SSTI, where preSSTI must be the lowest threshold
Doc. No 528501-v2