Caution Required for Packages

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.

It’s now less than a year until implementation of the revised Markets in Financial Instruments Directive (MIFID II), and European regulators are keen to nail down the last of the remaining policy details. One of the areas that looks close to being wrapped up is the transparency rules for package orders – but the proposed treatment, as it stands, could end up damaging the market for these important risk management tools.

Package orders combine several components – for example, a bond and a swap – in order to provide the end user with a tailored, specific hedge or trading exposure. By trading those components as a package, end users are able to achieve significant cost and execution efficiencies. While those benefits mean packages are regularly used as a whole, the fact each one can be so specific to a user means individual combinations might trade infrequently.

The fear is that these trades will become much trickier to execute under the proposed transparency framework. That’s because proposed rules published by the European Securities and Markets Authority (ESMA) in November would mean many highly bespoke and rarely traded packages are swept up in new pre-trade transparency requirements.

Why is this a bad thing? Simply, because requiring details of an infrequently traded product to be published before it is transacted is akin to a dealer showing its hand, giving market participants the potential to take advantage of that information. The end result would be greater execution risk and higher costs.

This, in turn, might force end users to abandon packages in favor of trading the components separately – a strategy that comes with more complexity and risk – or opt for simpler alternatives that do not exactly match their needs. In fact, European regulators themselves have accepted the negative consequences of a wide-scale pre-trade transparency regime for packages – which was what prompted the publication of the ESMA consultation on this issue.

We think ESMA should take a cautious approach, at least initially. For instance, we think it would be prudent to specify that a package should have no more than three components in order to be subject to pre-trade transparency requirements. All those components should be in the same currency, and they should come from the same asset class and sub-asset class (as specified under MIFID II). All the individual components should be liquid in their own right and should be traded on the same trading venue. Together, these changes will ensure that highly bespoke package trades that are unsuitable for pre-trade transparency will not get caught in the orbit of those rules.

It may be that once MIFID II is in place, and once ESMA has greater access to real-life data, these strictures might be relaxed, widening the pool of package trades that are deemed liquid. But, until there is more evidence, it would be wise to chart a conservative course to reduce the chance of market dislocation.

These technical recommendations may seem minor, but the effects of any misstep will echo far out into the market, possibly limiting end-user ability to perform legitimate and necessary risk management. The devil is in the detail, and these details will determine whether this market continues to function efficiently.

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