Regulatory arbitrage fears over Mifid post-trade reporting

EU regulators may use different reporting deferral periods for large or illiquid trades

Market paticipants fear optional deferral period would create fragmentation

Market participants fear regulatory arbitrage if European jurisdictions introduce different post-trade reporting times, under new rules that are supposed to harmonise transparency requirements across the European Union.

“I understand there is a national regulator looking at just two days because they have a big retail market. Whereas with another, I think there is a mind-set to do four weeks. That is going to put a big regulatory arbitrage there,” says a market structure expert at a global investment bank.

On January 3, 2018, the second Markets in Financial Instruments Directive (Mifid II) and its accompanying regulation (Mifir) will apply to EU financial markets. Within those rules are post-trade reporting requirements, which require the publication of the price and quantity of a trade 15 minutes after execution. The publication of post-trade reports can be deferred in three circumstances: if the transaction size is above large-in-scale thresholds; if the transaction is above a size specific to the instrument and the counterparty is taking principal risk rather than executing on an agency or matched principal basis; or if the instrument has an illiquid market.

The standard deferral period within Mifir is 48 hours, but the rules allow national regulators to extend the period of time before a party publicly discloses the size of a non-equity transaction to four weeks. It is feared different national regulators will offer different lengths of time for deferrals. As a result of the varying deferral periods, it is expected trades that qualify for a deferral will be traded in jurisdictions that offer the extended period.

Sources say national regulators are considering applying different deferral periods depending on the type of investors active in their particular markets

“You could see a potential shifting of liquidity to those jurisdictions that provide the four-week deferral, particularly for large transactions,” says a regulatory expert at an interdealer broker.

Sources say national regulators are considering applying different deferral periods depending on the type of investors active in their particular markets. A two-day deferral period is regarded as more appropriate for markets dominated by retail investors because it provides them with the maximum amount of transparency.

“If they are working off the premise that for retail markets they need to have the maximum amount of transparency because they are the least sophisticated markets, and so deserve the greater protections, they might choose to enforce the greatest amount of transparency,” says the market structure expert at the global investment bank.

For large financial centres like London, which have more institutional investors, regulators may choose to use a four-week deferral period because transactions tend to be larger, and so are more difficult to hedge or transfer into the market.

For different asset classes, the size of the retail market may be larger or smaller in different jurisdictions. For example, Italy has the largest retail investor base for municipal and corporate bonds in Europe.

Due to the calibration and phasing in of the liquid market test, fixed-income trading venue MarketAxess estimated around 97% of corporate bonds will be deemed illiquid and so qualify for a deferral of post-trade transparency.

Arbitrage warning

The risk of fragmentation between jurisdictions in the European Economic Area was highlighted by market participants in response to a December 2014 consultation conducted by the European Securities and Markets Authority (Esma) for writing the level two texts for Mifid II and Mifir.

Industry respondents pointed to the risk of the optional deferral period creating fragmentation and an unlevel playing field.

In its final report in September 2015, Esma stated it did not have the power to impose a standardised deferral period in the level two text. The standard-setter said it would recommend harmonised implementation but acknowledged the level one text of Mifir allows national regulators to exercise the deferral in different ways.

“It seems they are not playing that co-ordinating role, which is disappointing, because it does mean it can lead to regulatory arbitrage where people tend to execute more in those jurisdictions that have offered the four-week deferral rather than the deferral at T+2,” says the regulatory expert at the interdealer broker.

My assumption has always been if we saw genuine regulatory arbitrage then probably it would be something Esma would act upon pretty quickly

Jason Waight, MarketAxess

Best execution requirements may counteract the risk of regulatory arbitrage, as firms must show they executed at the best price for their client. Therefore, choosing a counterparty or venue based on the relevant deferral period being longer in that jurisdiction may not satisfy the best execution criteria.

“You would have to show in all cases that you have taken all sufficient steps for best execution. So I think, choosing a dealer because they happened to be in a more advantageous jurisdiction may not be in line with the rule,” says Jason Waight, head of regulatory affairs and business management at MarketAxess.

The best execution rule could in some circumstances, however, provide an advantage to trading with a counterparty in a jurisdiction offering the longer deferral.

“We could argue it could be in line [with best execution] because a greater deferral may make a dealer more inclined to give you a good price and take more risk,” says a regulatory specialist at a European trading venue.

It would also be difficult for trading venues and brokers to quickly take advantage of the regulatory arbitrage if they are not already established in the jurisdiction offering the longest deferral.

“It would be very hard to launch a fixed-income venue in a jurisdiction with a more favourable deferral regime quickly,” says Waight.

He continues: “My assumption has always been if we saw genuine regulatory arbitrage then probably it would be something Esma would act upon pretty quickly.”

Pick a format

The rules also give national regulators the option to select the way the information in the post-trade report is presented. National regulators can choose whether the deferred transactions should be published individually or in an aggregated format. The aggregated format allows all the transactions concluded in a particular instrument that qualifies for a deferral to be published in one report, aggregated across one week.

For market participants, this increases the uncertainty and complexity of understanding the regulatory treatment of their transactions.

One of the biggest challenges of Mifid II is, before you trade, working out where you are going to do it

Jason Waight, MarketAxess

“What is causing a lot of confusion on the market is if the regulator does choose to provide the four-week deferral, there are various publication options they can pick. So there is a bit of uncertainty as to what the requirements are going to be,” says the regulatory expert at the interdealer broker.

The reporting obligation always falls on one party in a trade, depending on the circumstances. If the trade is transacted on a venue or with a systematic internaliser (SI), then the reporting obligation is with the venue or SI. Where a trade is not placed on a venue or with an SI, the selling counterparty is required to report.

The different publication options teamed with the different deferral periods across jurisdictions create multiple layers of complexity traders will face before and after trading.

“One of the biggest challenges of Mifid II is, before you trade, working out where you are going to do it. Are you going to be on venue? Or are you going to be trading with a systematic internaliser? Will you have the reporting obligation? Will someone else have it? Will pre-trade transparency apply? Will my post-trade report be deferred? What is the deferral period? So there is potentially a lot of information you want to have as part of your execution strategy,” says Waight at MarketAxess.

He continues: “A lot of clients are trying to work out how they do all that. So it is another new piece of information you want in order to make an investment decision and is something we’re actively looking into.”