The MiFID II effect on consolidation
With its emphasis on increased market competition and pre- and post-trade transparency , MiFID II will reshape the trading of financial instruments in the EU when it takes effect in January 2018 . Crucially , the rules have expanded the definition of Systematic Internalisers ( SIs ). This will bring more firms within the criteria , while also broadening the product scope to capture a wider range of instruments . Institutions classified as SIs will face strict obligations around pre-trade transparency , quote and trade matching , best execution and reference data reporting . As a result , many participants are expected to seek to avoid the classification , leaving only a few , larger firms with the scale and balance sheet to manage larger-sized business .
Changing liquidity paradigm
Debate continues around what eventual impact MiFID II will have on the microstructure of equity markets . One area of concern is the Share Trading Obligation , which as it stands will force firms to undertake transactions on EU trading venues , rather than use non-EEA ones that may offer access to deeper liquidity pools . Broker crossing networks will also either have to cease or become a regulated market , MTF or SI , prompting order flow to move to lit venues or possibly electronic market makers . Until there is greater clarity over the eventual framework , business will likely flow to primary exchanges and traditional voice channels . In this environment , we expect a bifurcation of liquidity between low-touch electronic channels and block / strategic equity situations . These will mirror the asset management landscape , with an increased focus on alternatives ( including absolute return and active activist ) versus low-risk beta , passive-driven strategies .
Consolidation growing across the industry
Going forward , we envisage increasing consolidation in the number of global counterparties providing block liquidity , in response to the rising cost of capital ( fuelled by regulatorydriven capital requirements ) and lower business margins . Smaller-sized transaction business will be capped out in the dark . This trend is further exacerbated by the ongoing concentration of assets in the hands of a limited number of global multi-managers , which are seeing far stronger growth in AuM compared to the wider fund management universe – as evidenced by AuM growth of 80 % for trillion dollar managers since 2009 , versus 7 % in the wider market .
Shift to passives
The shift to index benchmarking continues to grip the global asset management industry , bringing stockholder concentration and significant liquidity challenges across global markets . In EMEA , we are somewhat behind the trend . However , the passive shift is clear , and with it we are already experiencing a negative impact on intra-day liquidity – as seen in the UK , where volumes in the LSE ’ s closing auction have risen from 15 % to nearly 35 % in the last five years . The focus on liquidity-driven instruments is equally evident across delta one and derivatives markets , compounding volatility and driving a broader emphasis on indices versus bottom up or single names . In US markets , futures volumes are up 42 % year-on-year at a time when cash equity volumes are down 17 %, reaffirming the top-down market bias . Similarly , listed index options have experienced a 28 % increase versus 4 % in single name options , highlighting the high correlation market environment .
OTC , swap markets and interbank liquidity
Across OTC and swap markets , bank regulation also remains the primary driver of lower liquidity , shifting liquidity to alternative products . Recent changes to initial and variation margin rules , along with obligations to centrally clear certain OTC instruments , continue to deliver a more transparent framework . At the same time though they have reduced interbank liquidity in the OTC interbank swap market , causing liquidity to move to an ever increasing number of listed futures contracts traded in the broker market . For example , following introduction of the US MRNCCD regulations and the EU ’ s initial margin requirements earlier this year , we saw a massive reduction in market activity for 1yr interbank OTC swaps , due to concern about the increased cost of funding the OTC activity , and as participants sought to minimise the operational impact of the changes and limit exposure to affected counterparties . Firms that have stepped into these markets and broader asset classes have focused on low capital-usage , electronic liquidity provision ( ELP ) business models . This trend has led to a more short-term focus on interim liquidity , and restricted the framework for wider risk dissemination across counterparties and products .
Reduced QE diminishes liquidity back stop
A reduction in central bank liquidity – as central banks across the world begin the process of rolling back asset purchases and eventually shrinking their balance sheets – will have the knock-on effect of removing back-stop liquidity across capital and secondary markets . We estimate the total size of QE and FX reserve expansion to have reached approximately US $ 12 trillion since the global financial crisis , with a compounding effect on global liquidity . With the slowdown and eventual end to central bank intervention , we will start to see a progressive reduction in liquidity across global markets . Asset allocation and risk management of these sovereign balance sheets will ebb and flow , but the roll off in fixed income will likely take place passively through the expiry of bonds as they mature , rather than active asset sales to unwind cash positions . However , equity and FX markets are unlikely to witness significant levels of QE unwind until 2019 and beyond .
Banks step into the breach
With markets witnessing a contraction in investor activity , bank intermediary capital will become increasingly important , as banks are called on to step in as intermediary liquidity sources and provide bigger blocks . At Citi , we are committed to developing custom technology and liquidity solutions designed to help clients navigate the challenging liquidity landscape . This includes developing a scalable platform , leveraging big data and machine learning , that enables us to provide efficient agency and risk solutions . It is complemented by a holistic approach to the provision of liquidity and services across asset classes and global markets – built on our universal product footprint , extensive client networks and ability to provide contra principal flow alongside central risk inventory – to ensure clients can meet their execution needs .
Summer 2017 www . buysideintel . com
23