In remarkably strong terms, the International Capital Market Association, the International Swaps & Derivatives Association and the Bond Market Association have come together to reject a key element of the Financial Services Authority’s proposals on implementing the EU’s Markets in Financial Instruments Directive (Mifid) best execution requirements. The proposal covers implementation of a benchmarking system. The UK regulator, without any prior consultation with trade bodies, got IBM to come up with a methodology. The idea is that dealers would use a benchmark price in a particular product to which an appropriate spread would be added, thus providing proof to a client of best execution.
Unfortunately this proposal is not only impracticable and likely to prove expensive for the industry but would probably also require significant change to market practices. The likely effect would be a withdrawal of liquidity in markets that are actually functioning healthily.
The concept of a benchmark price is a difficult one to pin down. In most fixed-income markets there is not a single true price for a product at a particular time, except for the most liquid markets, such as exchange-traded futures. Establishing a benchmark is far from straightforward in over the counter markets and the bond market is largely OTC. Just think about areas where there are two or three dealers. The FSA’s proposal suggests that the banks’ own internal models could be used to offer proof of best execution in these sectors. But this would leave the dealer open to significant market risk.
The concept of best execution might well turn into a nightmare for all concerned. Dealers will need to demonstrate that the best price was given, if the investor then – with hindsight – discovers a better price it can then come back to the original dealer.
The inadequacy of the FSA’s proposals suggest that the regulator either does not understand how bond markets work or is not very focused on fixed income. The whole approach of trying to copy and paste into the debt world rules that work fine in equity is unsatisfactory to say the least.
This is not the first time that regulations made with equity markets in mind have been imposed on the bond markets. Remember the Market Abuse Directive? One result of this regulation was a substantial reduction in credit research given to investors. Another was the immense difficulty caused to syndicate managers of debt new issues, where shorting is common practice, because of rules designed to stop abusive pricing of equity primary offerings.
Going back to basics, what is Mifid trying to achieve? It seems evident that the regulators believe that “consumers” need to be protected from big bad investment banks. But fixed income is a highly institutionalized sector where “consumers” are normally massive institutions in their own right. They don’t need protection. Retail bond investors do. But the tradition of direct retail investment in bonds is not particularly strong in Europe, except in Germany and Italy. And there is little evidence that these guys are getting stuffed, except in products that feature complex derivatives that they might be better off staying clear of anyway.
It would be unfair to say that regulators are deliberately trying to damage Europe’s debt markets. It is clear, though, that their general lack of understanding of its heterogeneity and complexity is causing lots of market participants lots of grief.
