MiFID II sends mixed messages to market makers – EURACTIV.com
Proposed revisions to the Markets in Financial Instruments Directive (MiFID II) are giving market makers, many of whom use high-frequency trading methods, mixed messages. This could harm their ability to provide liquidity to European financial markets, especially if their remuneration is limited by lawmakers, writes Johannah Ladd.
Johannah Ladd is the General Secretary of the European Major Traders Association (FIA EPTA), which represents companies across Europe that trade with their own capital. These market makers are intermediaries in the financial markets, who quote the prices of a financial instrument to buyers and sellers to facilitate trading. Today, the majority use automated and algorithmic trading methods.
The presence of intermediaries in the markets keeps the market liquid or fluid; so that investors can buy and sell easily and with low transaction costs. The MiFID II text currently under discussion contains several clauses that will have a profound effect on the practice of market making in Europe, determining the future liquidity of European financial markets.
MiFID II gives market makers mixed messages. On the one hand, European legislators have confirmed their crucial role in the markets by imposing obligations to remain on the market permanently.
This is all the more important as Europe wants to drive growth by increasing the number of companies raising capital on European stock exchanges (through IPOs or IPOs). Meanwhile, banks at all levels are retreating from market making and deleveraging (getting rid of debt). Without independent market makers, companies’ ability to raise capital would be limited, prices more volatile and markets more expensive to trade.
On the other hand, the same legislators seem to suffocate market makers with bureaucracy. The current proposals impose so many restrictions on market makers that if they come to pass, we will see many of these companies stop playing this role altogether. There is a danger that the patterns currently in circulation mean that in five years European market liquidity will be at an all-time low.
A crucial element of the market maker role is the ability to monitor and maintain price consistency across all trading platforms. In doing this work, market makers face two types of problems:
- an inventory management problem – how much stock to hold and at what price to buy and sell. Market makers earn money on these trades in the form of a bid-ask spread – reward for taking the risk that their inventory will lose value
- an information management problem. By providing both bid and ask quotes, a market maker exposes themselves to the risk of losing knowledgeable traders who know more about asset values. The bid-ask spread is designed to protect against this risk, and market makers can widen the bid-ask spread as a buffer.
Nevertheless, in recent history, bid-ask spreads have only narrowed, mainly due to improved technology. This has increased trading speed and enabled the development of automated, highly responsive and efficient risk management systems that allow market makers to process information and update quotes more quickly, limiting their exposure when prices turn sharp. obsolete.
This forces market makers to invest huge sums in technology and infrastructure, and even then they don’t make money on every trade, continuing to face real financial risk.
Accordingly, trading venues that wish to encourage market makers to provide tighter quotes choose to reward bona fide market makers with appropriate incentives and allow spread widening or temporary exits from the market. market in times of distress. This allows market makers to pause, assess and engage in prudent risk management.
These factors, combined, allow market makers today to contribute to the most efficient markets in history, while effectively managing risk and preserving market stability.
A proposed regulation can undermine this. Market makers may be required to stay in the market almost continuously, without the ability to stop trading when prudent risk management dictates stopping to value.
In addition, the incentives – which reward them for bearing the risk associated with providing liquidity – may be limited. Minimizing or removing incentives in the form of rebates or other compensation already raises doubts that market making continues to be profitable. But proposals to put in place systems to further penalize companies that might fail to meet strict listing requirements mean they risk becoming loss-making.
It should be remembered that modern markets have greater transparency of order flow information than ever before; the traditional advantage of dealers in the investment market no longer applies. As this advantage is reduced, so are the regulatory requirements imposed on those who expose themselves by offering prices to both buyer and seller.
At a time when economic recovery is sorely needed, policy should free companies that play the critical market-making role to continue providing this social benefit, recognizing their need to manage their risks and be compensated according to the risks they bear and the services they provide. We believe that regulation should be a framework for market participants to make wise choices and operate responsibly and efficiently, not to replace free choice.
In the final analysis, if rules prevent market makers from carrying out their work safely or economically, then they can become obsolete, making markets less liquid and therefore undermining their fundamental societal role of distributing market capital. those who have it to invest. to those who need it to generate economic growth.