ViewPoint
September 2012
Regulatory Reform of European Debt Markets
Balancing the costs and benefits
BlackRock manages the investments of its clients through their
pension, savings or collective investment schemes. As of 30
June 2012 we have over €175 billion of our clients’ money
invested in European debt.
Financial regulatory reform fundamentally impacts asset
managers and investors. As a fiduciary for our clients, BlackRock
In this paper, we focus on whether the current reform of
supports the creation of a regulatory regime that increases
European fixed income market structure would bring added value
transparency, protects investors, and facilitates responsible
for end-investors or if the costs of proposed reforms exceed their
growth of capital markets, while preserving consumer choice and
potential benefits. We give an overview of the characteristics of
assessing benefits versus implementation costs. However, the
European fixed income markets and consider if these markets
Review of the Markets in Financial Instruments Directive (MiFID)
could actually accommodate the macro- and micro-level changes
in Europe could herald an unprecedented shift in how fixed
that are being proposed. In conclusion, we provide
income market makers would be obliged to report to regulators
recommendations to address the public policy intentions behind
and to the market. Execution venues for all asset classes are
the reforms whilst protecting the fixed income markets from
being redesigned and re-categorised. The regulatory pressures
increased liquidity pressure.
on broker-dealers making markets in fixed income - from
regulation and from the on-going Eurozone crisis - are
“Non-equity” markets are “non-equity”-like
significant.
The MiFID framework was designed for equity and “equity-like”
instruments. Instruments that are not equity are labeled “non-
This ViewPoint considers if European corporate debt markets
equity” in the European Commission’s drafting. This broad
can withstand the challenges they currently face from the current
category includes fixed income. Logic dictates that a comparison
macro-economic conditions coupled with an intense period of
will be drawn in policy-makers’ minds between the category not
regulatory change. Whilst end-investors would be exposed to
conforming to the default, in this case non-equity to equity. It
higher frictional costs arising from regulatory change, the
could be tempting to suggest that non-equity markets should
premium they receive for investing in debt is generally
report and be structured like equity markets, unless there is a
decreasing. This scenario presents significant challenges to
very good reason not to do so.
households and individuals that are saving to ensure their
financial security into retirement.
Summary of our Recommendations for the Regulation of European Fixed Income Markets
Appropriate market structure
Focus on post-trade transparency more valuable than
pre-trade transparency information
We support the introduction of the Organised Trading Facility (OTF)
category through the MiFID Review. To preserve liquidity provision
We believe that improving the level and consistency of post-trade
in fixed income markets, proprietary capital should be allowed to be
information would address the regulatory concerns underlying
used in the OTF to facilitate client orders. We furthermore believe
current pre-trade transparency arrangements in fixed income
that proprietary capital should be flagged in the OTF so that
markets. The focus on achieving a robust and dynamic post-trade
investors interacting with that capital better understand the nature of
reporting system would bring benefit without disrupting the market.
the counterparty trade.
Retail participation in fixed income through pooled
Calibrated and dynamic post-trade transparency
products
We believe that a TRACE-like model could be adapted to the
Investing in bonds through a pooled vehicle is more beneficial than
specificities of European fixed income markets and applied to deliver
direct investment by retail clients in debt instruments. This is mainly
the benefits to markets and to end-investors from more consistent
due to the diversification benefits which reduce the effects of
post-trade transparency information.
asymmetric returns, otherwise inherent in retail investors holding
bonds.
The opinions expressed are as of September 2012 and may change as subsequent conditions vary.
2
BlackRock supports a general drive to greater transparency
Figure 1: Equity vs Fixed Income Issuance
keeping both liquidity and price in mind, across all financial
instruments, since transparency facilitates the efficient transfer of
capital from investors to issuers. When the cost of that transfer
is priced in an economically rational way, frictional costs, such as
those arising from inefficient regulation, distort the pricing
equilibrium, so the greater the frictional cost, the more distorted
the capital transfer mechanism from investors to issuers
becomes. End-investors, like corporates, benefit most when the
capital transfer mechanism is as efficient as possible, taking on
the risk with which they feel comfortable, in the most transparent
manner. Efficient capital transfer mechanisms furthermore
create liquidity and liquidity ultimately reduces costs for end-
investors as well as stimulating long-run economic growth by
facilitating the financing of corporates.
Well-functioning markets strike an appropriate balance between
pricing transparency requirements and, for example, the
protection of trading intentions or market footprint for large
Source: Bloomberg, BlackRock
orders, such as those asset managers would execute on behalf
only the less liquid equities depend on quote driven market-
of several institutional clients (e.g., pension funds).
making since equity is generally an order driven market.
Fixed income and equity markets differ fundamentally in terms of
► Institutional investors (typically pension funds, insurance
the frequency and volume of issuance into the market and in
companies, sovereign wealth funds and other official
terms of the resultant liquidity concentration:
institutions) tend to invest fixed income for the long term with
►
a buy and hold approach. Fixed income appeals to these
Primary market issuance in fixed income is significant but
more risk-averse investors since bonds offer a specific yield
secondary market trading is thin. Contrast this with equity
to maturity. Equity, by contrast, is often used as a tradable
where the inverse situation is true – outside of infrequent
portion of a portfolio with investors seeking higher returns
IPOs, the equity market is a secondary market. Importantly,
than with bonds.
one company may issue numerous bonds with different
maturities and coupons, whereas the same company will
► The fixed income market is primarily a wholesale market.
generally have one class of equity.
Direct retail participation in bond markets is low. Where retail
►
participation in bond markets is said to exist it is usually
Euro investment grade debt issuance decreased by 15%
through a high degree of intermediation by banks that
from the first half of 2011 to the first half of 2012 whereas in
package, structure and/or re-sell debt instruments to retail
the equity market primary issuance more than halved during
investors, since the fixed income market is per se an
the same time period. Equity investors have been particularly
institutional market.
deterred from investing in IPOs because of the large macro
uncertainty that currently exists in Europe, whereas debt
In light of these significant differences in market characteristics
issuers have financing needs that require continued access
between equity and debt, regulatory solutions for the equity
to the market – see figure 1.
market are only appropriate for instruments that most closely
share equity-like liquidity characteristics. We make suggestions
► This implies that while equity fits the continuous liquidity
in the conclusion to strike the balance between debt market
exchange trading model, fixed-income instruments typically
specificities and the wider public policy goals of increasing
trade over-the-counter (OTC).
transparency.
► Commensurately, market-making activity in fixed income
markets is vitally important. This results in a typically quote
Market conditions - a snapshot of the European corporate
driven market with the ability for an asset manager to
debt markets today
immediately risk transfer to a liquidity provider with inventory
Supply of primary market debt issuance in Europe is currently
most often held on bank balance sheets to facilitate
below the 10 year average with a decreasing volume trend - see
secondary market liquidity. Contrast this with equity, where
figure 2.
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Figure 2: European IG Issuance
Generally, New Issue Concessions (NIC) – the discount in the
price of a security offered in a new issue or a secondary
distribution – is a function of market volatility and demand,
generally rising as market volatility increases. However,
currently we observe that NICs are tightening despite volatility in
Eurostoxx due to inflows into investment grade (IG) asset
classes – see figure 4.
Figure 4: NIC vs Eurostoxx
Source: BlackRock, JP Morgan
Since the onset of the financial and Eurozone crisis, there has
been a significant drop off of European financial issuance from
highs in 2007 due to bank balance sheet de-levering and limited
(and expensive) access to the market – see figure 3.
Figure 3: Financials vs Industrials IG Issuance
Source: BlackRock
Going forward, we expect financial issuance to remain low as
banks continue to de-lever balance sheets with some of the de-
leveraging being due to the lack of “pass through issuance”
where financials borrow from primary markets and lend to
corporates. When stability returns to European markets we
would anticipate a slight increase in industrial issuance volume
as they replace their bank funding with corporate bonds.
However, for now due to the low levels of primary market
issuance caused mainly by the challenges posed by the
Eurozone crisis and re-capitalisation of banks, European
corporate debt markets are under strain and are possibly even
less “equity-like” than they have ever been.
Regulatory change - details are important
Source: JP Morgan
Under the MiFID II proposals, the public policy goal is to
encourage all trading onto regulated trading venues, with
In addition, with sustained volatility in European markets, issuers
consistent level of pre- and post-trade price transparency
have increasingly been accessing the US dollar markets to fulfill
required of each venue.
their funding needs.
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Currently, MiFID imposes harmonised pre-and post-trade
Theory suggests that transparency may reduce adverse
transparency requirements only on equity shares admitted to
selection, and that in turn will reduce bid-ask spreads on
trading on regulated markets. The European Commission
average. Greater transparency may also reduce search costs for
proposes to introduce pre- and post-trade transparency
investors. When investors search more, this increases
requirements for other instruments as well, including fixed
competition among dealers, which narrows spreads.
income and across all trading venues. The Commission
acknowledges the different structure of markets in non-equity
On the other hand, greater transparency could reduce the supply
instruments compared with those in equities, so it has proposed
of liquidity. Once a liquidity supplier has purchased securities, he
to tailor the exact transparency regime to the instruments in
usually endeavours to re-sell at least part of the purchase, to
question, which is welcome.
manage inventory. If his competitors have observed this initial
trade, however, they may be tempted to react opportunistically.
► Pre-trade transparency requirements – disclosure of the bid
Knowing he needs liquidity and is willing to pay for it, they will
and offer price: regulators will be able to use a waiver for
adjust their prices. Thus after large trades in transparent
specific type of instruments based on market model, liquidity
markets, liquidity suppliers trying to unwind inventory can be in a
or other relevant criteria. They will also be able to apply a set
weak bargaining position. This will increase the margin, or widen
of different waivers to exempt some transactions from the
the bid/ask spread, they will require from investors to offer
transparency requirements.
liquidity risk in the first place and ultimately impact the returns
►
end-investors receive on their savings.
Post-trade transparency: the proposed provisions set the
possibility for deferred publication in certain cases, depending
Whereas an appropriate level of transparency is beneficial for
on the size or type of transactions. The details of the relevant
investment, conversely, incompatible “equity-like” levels of
transparency regime will be crafted by the European
transparency applied to fixed income markets could reduce
Securities and Markets Authority (ESMA) following political
information acquisition and revelation in the market place, with
agreement of MiFID, currently anticipated for end-2012 or
the following consequences:
early 2013.
► From the issuer’s perspective, smaller, lower rated bond
► Market participation and liquidity provision: since fixed
issuers would have to pay a greater yield to raise capital via
income is an inventory-based market that relies on banks to
bond issuances in a less liquid market and may not be able to
facilitate secondary market liquidity with their own capital, the
issue bonds at levels that are economically viable to them.
proposed MiFID rules regarding systematic internalisers1 are
Overall it is likely that the cost of raising capital would rise.
additionally important.
► A poorly calibrated pre-trade transparency regime would
Greater transparency is desirable, in theory
particularly impact smaller less liquid bonds, such as those
The European Commission believes that the absence of
corporate issues trading on the secondary market. It would
harmonised transparency requirements in non-equity markets
also discourage market makers from providing liquidity or
leads to lower market efficiency and higher risks “than would
holding inventory in such issues. This would, in turn, depress
otherwise be the case”. By extending equity-like pre- and post-
investor demand or would lead to investors requiring a higher
trade transparency requirements to fixed income markets the
risk premium to compensate for the reduced liquidity.
Commission expects this additional transparency to the market
► From the end-investor perspective, for investors mandated to
could encourage greater retail participation in fixed income. The
hold bonds as part of their investment strategy, the tendency
Commission justifies the requirement to publish two-way quotes
will be to invest predominantly in only sufficiently liquid
in fixed income by emphasising the need for a level playing-field
bonds, to minimise market impact and trading costs. Many
with other trading venues, supporting market-wide price
investment mandates are already restricted to a limited
discovery, and to protect retail investors.
universe of the strongest sovereigns and the largest
However noble the public policy objective, when the theory
corporates.
meets the practice, a number of serious unintended
The adverse market activity will reduce the ability of investment
consequences for market efficiency and liquidity could result in
managers to diversify their portfolios, impede the ability of
diminished returns and investment possibilities for Europe’s end-
companies to finance their future growth and hinder some
investors.
governments’ ability to finance their debt, to the detriment of the
wider European economy as a whole.
1 An investment firm which, on an organised, frequent and systematic basis, deals on own account by executing client orders outside a regulated market or an MTF
(Source: FSA Handbook)
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Recommendations
Recommendation 3 – Focus on post-trade transparency
more valuable than pre-trade transparency information
In view of these observations, we make the following
for markets and end-investors
recommendations:
Pre-trade transparency is currently available to market
Recommendation 1 – Appropriate market structure
participants (i.e. streamed prices, RFQ platforms, order books
We support the introduction of a new trade execution category in
such as LSE or Bond Match) although it is up to each investor or
the MiFID Review – the Organised Trading Facility (OTF). The
institution to make use of it and offer the best execution services
OTF would, we believe, effectively capture OTC trading in
to the clients. The concerns regarding the impact of a non-
regulation and apply a comparable standard of disclosure and
harmonised, non-equity like, pre-trade reporting that have been
reporting to other trading venues thereby improving information
expressed by policy makers are, we believe, largely unfounded.
to the market. To preserve liquidity provision in fixed income
markets, proprietary capital should be allowed to be used in the
We believe that improving the level and consistency of post-
OTF to facilitate client orders. We furthermore believe that
trade information would address the regulatory concerns
proprietary capital should be flagged in the OTF so that investors
underlying current pre-trade transparency arrangements in fixed
interacting with that capital better understand the nature of the
income markets. The focus on achieving a robust and dynamic
counterparty trade.
post-trade reporting system would bring benefits for systemic risk
reduction without disrupting the market, especially during the
Recommendation 2 – Calibrated and dynamic post-trade
current period where a liquidity challenge already exists.
transparency
The MiFID Review presents an opportunity to address regulatory
Recommendation 4 – Retail participation in fixed income
through pooled products
concerns around opacity in European fixed income markets.
The investor experience of TRACE – the FINRA-regulated
We support initiatives to facilitate further retail investment in debt
Transaction Reporting and Compliance Engine launched in the
since the risk profile of fixed income is an important building
US in 2002 – has been generally positive. Importantly, TRACE
block of any investment portfolio. However, there are several
was phased in over time, allowing the market to adapt to the
reasons why retail participants investing directly in individual
reporting requirements and thereby the liquidity impact of its
bond securities rather than owning a bond fund would be sub-
introduction was limited. The reporting window has
optimal from the end-investor perspective:
subsequently narrowed over time. While some may point to
►
shortcomings with the reporting engine, we believe that these
Bond markets are not as widely followed by retail investors
can be addressed.
as, say, equity markets. Therefore there is a lack of
coverage and lack of sufficient information to make informed
We recommend adapting a TRACE-like model to the specificities
decisions on a security level.
of European fixed income markets and applying this solution to
► Proper diversification is difficult to achieve as many issues
deliver the benefits to markets and to end-investors from more
have large minimum trading sizes and may be out of reach
consistent post-trade transparency information.
for retail investors.
What is TRACE?
► Efficient execution is not guaranteed as small trade sizes can
have bid-ask spreads that negate many of the benefits from
TRACE was launched in 2002 by FINRA to increase transparency
holding the security especially in the low yielding
in US fixed income securities. At that time, dealers were required
environment. Also, liquidity is not guaranteed during the
to report all secondary OTC market transactions in domestic public
times of stress in the market.
and private corporate bonds to TRACE. Government bond (US
Treasury) markets were subsequently considered sufficiently
Many of these risks are mitigated when investing in bonds
transparent that TRACE reporting would not benefit the market
through a pooled vehicle. First, pool vehicles are typically
and have since been excluded from reporting requirements.
managed by professional investment managers who more
Dissemination from TRACE to the public also started July 2002.
closely follow the bond markets. In addition, due to the
Over a period of about two years, FINRA gradually expanded the
dissemination rules such that data on all publicly traded corporate
increased size of the transactions at the fund level, diversification
bonds were made available. FINRA initially gave 75 minutes for
can be more easily achieved and execution is relatively more
dealers to report into TRACE then gradually tightened the
efficient. There are already many well established pooled
reporting window down to where it stands today at 15 minutes.
vehicles structures available for retail participation.
The vast majority of trades are reported in near real time. TRACE
reporting and dissemination for Agency bonds (e.g., Fannie Mae,
BlackRock welcomes the opportunity to explore these issues
Freddie Mac and FHLB) began March 2010 and works similar to
further. We support constructive engagement with policy makers
investment grade corporates.
to find the balance between fulfilling stated public policy
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objectives and ensuring that the already precarious liquidity
recommendations in this ViewPoint are intended to address
situation in European corporate debt markets is not exacerbated
policy issues while also delivering a positive outcome for end-
by untimely or inappropriate regulatory reform. The
investors.
This paper is part of a series of BlackRock public policy
ViewPoints and is not intended to be relied upon as a forecast, research or investment advice,
and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of
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