Coming up… more regulations

Regulations and policy changes became aneveryday feature of markets following the global economic crisis but as in many aspects of financial services, for fixed income investments, their influences are far from over.

Increased bond trading transparency is one of the goals targeted by Europe’s second-phase Markets in Financial Instruments Directive (Mifid II). Due for implementation in 2018, Mifid II will require spread information to be published – pre-trade – for bonds deemed sufficiently liquid. The work involved in obtaining transaction and reference data for each instrument before the number-crunching to determine issue liquidity can even begin, is such that investment firms, trading venues and supervisors need to begin this year to rebuild their transaction and reference data reporting systems.

According to the European Securities and Markets Authority (ESMA), under the Mifid II requirements some 2,600 bonds, mostly government debt, out of the 50,000 traded in the EU will face greater, pre-trade transparency.1 Effectively
under the planned regulations, bonds deemed to be liquid have to conform to ‘real time’ transparency obligations. Exemptions are available for trades which are of a certain size. As such Mifid’s requirements to publish bid/offer spread information, should affect just 5% of the EU market. Nonetheless, there have been harsh critics, most of which concern what the initiative will do to market liquidity.

Steven Maijoor, ESMA chair, believes protecting the liquidity of the bond market is paramount but says introducing greater transparency to EU fixed income trading is a matter of carefully calibrating liquidity thresholds. “Transparency applied indiscriminately to illiquid instruments can be extremely damaging, resulting in difficulties in executing trades and the thinning of already thin markets. However, I am not aware of any liquid market which is not also reasonably transparent.” As such, Maijoor says, ESMA’s rules on bond
liquidity and transparency, which are the result of two years’ work where bond data was “put under the microscope” represents in his opinion, “the best technical approach permitted within the construct of Mifid II.”

Improving liquidity
In addition to Mifid II, there are also plans to revise the EU prospectus regulations. As part of the action plan for Capital Markets Union, the European Commission proposes to overhaul the existing regime to improve access to finance for companies as well as to simplify information for investors.

As part of this the intention is to remove the distinction between retail and wholesale denominations for debt securities. The latter can be offered without a prospectus provided the amount issued, per unit, is above €100,000. As such most investmentgrade issuers are incentivised to issue in large denominations in order to avoid the existing prospectus burden. The removal of this threshold could consequently create greater secondary market liquidity by creating a deeper market, while retail investors would also have access to a broader investment choice, according to the Commission.²

Other prospectus amendments that could impact fixed income liquidity include: lighter-touch requirements for smaller companies; allowing the creation of shorter and clearer prospectuses to provide better investor information; and simplifying secondary issuance through the use of a new, simplified prospectus for those already listed on a public market who want to do further capital raisings.³

Companies have to issue a single-i KID
However, while amendments to prospectuses may aid corporate bond issuance across Europe, amendments to another disclosure regime – due to be enacted from December 2016 – may impact it negatively. EU policymakers have been progressing Packaged Retail and Insurance-based Investment Products (Priips) regulations, much of which deal with disclosure documents similar to the existing Ucits key investor information documents (Kiid). Under the existing Priip proposals companies have to issue a single-i KID (key information documents) for all types of investment products. (While eventually the KID will replace the Kiid, until 1 January 2019 Priips will not apply to Ucits funds. The UK’s non-Ucits funds may have to adhere to Priips earlier.)

The new Priips pre-contract disclosure document will contain, in broad terms, certain standardised information such as the nature and main features of the product, its risk and reward profile and costs. It is this aspect of the forthcoming regulation that is creating some concern with respect to fixed income instruments.

The cost section of the KID aims to aid consumers in understanding what the costs of a Priip will or could be and what effect they may have on the possible return.

As such the current draft rules require providers to present transaction costs – highlighting the difference between the value of an asset at the point at which the order is initiated and the price at which the Priip transacts in that asset. In other words they are expected to point out the difference between an asset’s arrival and its execution price multiplied by the quantity traded. The difference between the pre-sale price and that at which an asset is bought can be wide and in the case of fixed income, be highly influenced and exacerbated in low liquid, high volatility environment. This in turn may not just be off-putting to investors when they see the implied price move but can add to confusion and consequently, aversion.