MiFID II is giving market makers mixed messages
The presence of middlemen in the markets keeps the market liquid, or
flowing; so investors can buy and sell easily and with little transactional
cost. The MiFID II text currently under discussion contains several clauses
that will have a profound effect on the practice of market making within
Europe, determining the future liquidity of the European financial markets.
MiFID II is giving market makers mixed messages. On the one hand,
European lawmakers have confirmed their crucial role in the markets by imposing
obligations to stay in the market all the time.
This is particularly important as Europe wants to stimulate growth by
increasing the number of companies raising capital on European securities
exchanges (through initial public offerings or IPOs). Meanwhile, banks across
the board are retreating from market making and deleveraging (getting rid of
debt). Without independent market makers, companies’ ability to raise capital
would be constrained, prices more volatile, and the markets all around more
expensive to trade.
On the other hand, the same lawmakers seem to be suffocating market
makers with bureaucracy. Current proposals place so many restrictions on market
makers, that if they come to pass, we will see many of these firms simply cease
performing that role altogether. There is a danger that schemes now in
circulation will mean that in five years, European market liquidity will be at
an all-time low.
A crucial part of the market maker role is the ability to monitor and
keep prices consistent across trading venues. In doing this job, market makers
face two types of problem:
- · an inventory-management problem – how much stock to hold and at what price to buy and sell. Market makers earn money from these trades in the form of a bid-ask spread - reward for taking the risk that their inventory loses value
- · an information-management problem. By providing both bid and ask quotes, a market maker opens himself up to the risk of losing out to informed 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 decreased,
due mainly to improved technology. This has increased the speed of trading, and
enabled the development of automated, highly responsive and effective risk
management systems that allow market makers to process information and update
quotes more quickly, limiting their exposure when prices become out of date.
This requires market makers to invest huge amounts in technology and
infrastructure, and even then they do not make money on every trade, continuing
to face real financial risk.
As a result, trading venues who want to encourage market makers to
provide tighter quotes choose to reward bona fide market makers with
appropriate incentives, and to allow the widening of spreads or temporary
market exits in times of distress. This enables market makers to pause, assess
and engage in prudent risk management.
These factors, combined, make it possible for market makers today to
contribute to the most efficient markets in history, while managing risks
effectively and preserving market stability.
Draft rules may undermine this. Market makers may be obligated to stay
in the market on a near continuous basis, without the flexibility to stop
quoting when prudent risk management would dictate pausing to assess.
In addition, incentives – which compensate them for bearing risk
involved in providing liquidity – may be limited. Minimising or removing
incentives in the form of rebates or other compensation already makes it
doubtful whether market making will continue to be profitable. But proposals to
implement systems to further penalise firms who may not meet stringent quoting
obligations mean that it is likely to become loss-making.
It’s worth remembering that modern markets have greater transparency of
order flow information than ever; the traditional advantage dealers had over
the investing market no longer applies. As this advantage is reduced, so should
the regulatory requirements on those who expose themselves through quoting
prices to both buyer and seller.
In times where economic recovery is a must, policy should free up firms
serving the critical role of market making to be able to continue to provide
this social benefit, by recognising their need to manage their risks and be
compensated commensurate with the hazards they bear and services they provide.
We believe regulation should be a framework for markets participants to make
sound choices and operate responsibly and efficiently, not the replacement for
free choice.
In the final analysis, if rules make it impossible for market makers to
carry out their job safely or economically, then they may become obsolete – making
markets less liquid, and therefore undermining their fundamental societal role
of distributing capital from those who have it to invest to those who need it
to generate economic growth.
Content belongs to EurActiv.com For the original please visit: http://www.euractiv.com/sections/euro-finance/mifid-ii-giving-market-makers-mixed-messages-303467
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