Liquidity Is King

ISDA Chief Executive Officer Scott O'Malia offers informal comments on important OTC derivatives issues in derivatiViews, reflecting ISDA's long-held commitment to making the market safer and more efficient.

While it is summertime, the livin’ is not (always) easy. The EU regulatory process continues unabated and with the publication of a first complete Compromise Text on MiFID 2/MiFIR earlier this summer, the journey to trading obligations and platforms in the EU has well and truly begun. The process will take another step forward with the ECON Committee vote in the European Parliament, scheduled (after a postponement) for late September.

One of the big questions that remains unanswered in the MiFID/MiFIR debate – and that explicitly needs to be addressed before its resolution – relates to liquidity.

There are two aspects to this issue. One has to do with the use of liquidity as a benchmark or trigger for determining whether a rule applies to a particular obligation. The second has to do with the impact of the rules on the liquidity of traded financial instruments.

First things first: On the subject of a liquidity trigger, at what point should a financial instrument or market be considered liquid enough to support particular regulatory obligations? Such obligations might include those related to mandatory central clearing of OTC derivatives; mandatory trading of derivatives on regulated venues; or pre- and post-trade public transparency. That question is at least in focus in the MiFIR debate. Much less attention is being paid to an equally important question: when does an instrument or market stop being liquid enough to support those obligations; and how do you suspend them?

This is not just an academic discussion. Various provisions in the MiFID/MiFIR proposals reference liquidity as a trigger for particular obligations (notably the trading obligation and pre-trade transparency requirements).

Moving now to the second issue, the impact of the proposed rules on liquidity: To what extent could additional regulatory obligations increase or impair the existing liquidity of a particular financial instrument or a market as a whole? To be fair, some policymakers show awareness and sensitivity to this issue.

In the continuing dialogue over the proposed rules (particularly over the trigger issue), it is important that policymakers consider the potential for liquidity to vary over time. To put it bluntly, there is no market where permanent liquidity can be guaranteed (or, by the same token, mandated). This might reflect changes in market conditions in general, or simply the nature of the individual product.

Changes in liquidity levels could be inherent to the product in question, with liquidity falling in the period after the conclusion of the contract. For example, an ‘off-the-run’ credit index contract is likely to be significantly less liquid than the ‘on-the-run’ equivalent. And, even for an on-the-run index, the five-year maturity will be liquid where, say, the four-year is not. Changes in liquidity levels could also reflect external factors, such as weakening in the supply of credit. For this reason, it is important that the market infrastructure is sufficiently flexible to accommodate any change in liquidity.

In addition, given the potential for liquidity to change, liquidity triggers should also typically be two-way, i.e. the trigger should not only define when a particular regulatory provision applies, but should also define when the provision ceases to apply. Ideally, it should be possible to suspend particular obligations immediately, to ensure that markets continue to function (albeit with less turnover) during times when liquidity is stressed.

It has long been our view that legislative reform should support liquidity in the interest of systemic resilience, should protect the funding requirements of corporates and sovereigns and should advance the principle of strong risk management. And to that end, we support linking obligations to liquidity in appropriate circumstances. However, liquidity triggers:

• Must consider the various factors that collectively constitute liquidity;
• Must be forward-looking;
• Must be two-way so that obligations can be disapplied when necessary.

There are many welcome and positive developments in the Compromise Text. However, where the European Securities and Markets Authority (ESMA) is given the task of determining or applying a liquidity trigger, then its mandate should be such as to allow it to consider all relevant factors.

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