Post-MiFID II RTS: What Next for Fixed Income in Europe?

By Rebecca Healey, TABB Group

Originally published on TABB Forum

One of the key aims of MiFID II is the extension of the transparency regime to bonds. As a result, firms need to make traditionally opaque processes more transparent, and both buy- and sell-side firms need to reposition their business models, trading strategies and roles in liquidity provision. In addition, there will need to be a wholesale embrace of automated workflows for firms to understand their obligations for individual orders at any time during the execution process.

The world of fixed income trading in Europe is changing – and fast. ESMA has now published its Regulatory Technical Standards (RTS) outlining its expectations on how firms should implement MiFID II. One of the key changes to this piece of European regulation is the extension of the transparency regime to bonds. The impact of this change was not underestimated at the well-attended Fixed Income Leaders Summit in Barcelona last week. Conversations were dominated by the impact of MiFID II and how firms can best prepare ahead of 2017. Yet less than a third of the attendees admitted to having a strategy positioned to deal with the oncoming regulation.

While the RTS have yet to be endorsed by the European Commission and are subject to approval by the European Parliament and the Council, the regulatory direction is clear. Firms need to make traditionally opaque processes more transparent, and both buy- and sell-side firms need to reposition their roles, business models and trading strategies as a result. There will need to be a wholesale embrace of automated workflows – front to back – for firms to understand what their obligations are for individual orders at any given time during the execution process: pre-, post- and at-trade.

These obligations have added significance given that regulation is occurring at the same time as profound structural change within the European fixed income markets. Whether this is because of, or aside to, European regulation is up for debate; the reality is the world order axis already has begun to pivot. European investment banks are fighting to keep a seat at the table, choosing to realign capital to ensure they deliver a return on equity. This is changing both the products and services they are willing to offer their clients, as well as selecting which clients will be the beneficiaries.

This shift follows remarkable similarity to the juniorization of the equities desks post the European crisis of 2012; there, the loss of high-touch service provision led to a wholesale embrace of algo trading and dark pools, smart order routers and HFT. However, equities automation led to many outcomes that heads of dealing desks will not want to replicate, nor should they. Both the asset class and the time demand alternative responses.

While a true agency model is difficult to replicate without a central limit order book, the view that you will always need principle price makers to warehouse risk from non-matched trades misses the level to which technology and automation have also provided benefits to equity trading. The previous lack of transparency in equity executions has been radically enhanced by FIX trading and tagging of order flow. The requirement to deliver best execution has resulted in a flood of data, analytics and TCA offerings, with firms no longer focused on just gathering data, but gathering the right data to create meaningful output.

The first step for fixed income will be improving this access to and accuracy of data flows. However, current automated processes are still built around order facilitation – not necessarily order creation. More flow, more data points, more analytics will equate to a reduction in information flow controlled by traditional bilateral trading desks placing it in the hands of the buy-side dealer.

Greater transparency does not automatically equate to improved liquidity. Much has been said of the reduction of liquidity in secondary markets, but liquidity is not only reducing – it is fragmenting and shifting, and market structure needs to adjust as a result. Investors still need to find and access liquidity, but many electronic platforms are far from where they need to be. While industry incumbents struggle to adapt to requirements, it may yet take a new disruptor to deliver the amalgamation of liquidity now required.

The current challenges in all-to-all or buy-side-to-buy-side models is that most buy-siders trade the same way, added to which the growing imbalance in the number of buyers and sellers as well as liquidity concentrating in a smaller range of assets will all require new approaches to age-old problems. The shift in asset ownership from sell to buy side will underpin the need for the buy side to step up and become price makers as well as price takers to unlock liquidity through order creation. This will create further challenges to workflows and skill sets, as well portfolio mandates.

Innovation in fixed income capital markets has only just started. The tipping point may be transparency requirements or it may be automation of workflow processes, but both will shift fixed income trading from a capital-intensive, principal-based bilateral workflow to a collaborative, quasi-agency automated model. Fixed income has the opportunity to take the best of equities and FX automation and advance this to the next level.

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