‘The Desk’ Industry Viewpoint: Fixed income & MiFID II by Stefan Hendrickx
This article first appeared in The Desk, 3rd February 2016.
Fixed income & MiFID II: Making sense of market abuse scenarios in an RFQ world
It is perhaps not surprising that regulation topped the agenda at this year’s Fixed Income Leaders Summit in Barcelona, which took place two weeks after ESMA’s MiFID II Regulatory Technical Standards (RTS) were issued.According to analyst, Rebecca Healey, “Conversations were dominated by the impact of MiFID II and how firms can best prepare ahead of 2017. Yet less than a third of the attendees admitted to having a strategy positioned to deal with the oncoming regulation”.
One of the key changes MiFID II/MiFIR is expected to bring to fixed income markets is the extension of the transparency regime to bonds. Liquid instruments will be subject to strict pre-trade transparency with requirements of request-for-quotation-based (RFQ) venues to publish bids, offers and depth of market. Because of this increased regulatory attention, firms can no longer put off the requirement for implementing a capable market surveillance system as required under the associated Market Abuse Regulation (MAR), due to be implemented in 2016. National regulators are also casting a questioning eye towards the fixed income markets with the FT recently reporting: “…the FCA is pushing MTF operators to upgrade their monitoring of market abuse, describing the majority of surveillance systems in February as ‘poor’”.
New methods required
Market surveillance technology is designed specifically to detect and to make evident any wrongdoing within the capital markets. In recent years, surveillance firms have been in competition to handle large quantities of data in central limit order book markets. However, with the emphasis now being placed on the fixed income (FI) products, analysis of the data collected can no longer make use of the usual methods used to identify market abuse scenarios. A complete rethink is due.
Benchmarking example: Fixed income surveillance vs the prevailing model
A simple example of where the prevailing cash equity model of surveillance breaks down for FI markets is in the construction of a reference price to help identify outliers. Typically this involves the ‘overlaying’ of proprietary trading data with a wider data set.
Many fixed income securities, however, are not permitted the luxury of a readily available market price due to their illiquid nature. Lack of a market price makes direct relative pricing analysis inaccurate and, in many cases, impossible. To overcome this, surveillance platforms often make use of composite pricing feeds taken from data vendors in order to permit the analysis of FI products for relative pricing analysis. These platforms help clients by providing a visualisation of the RFQ compared to a composite price, allowing the compliance officer to immediately see if the client has beaten the market price when trading. Being able to analyse and visualise data in this way is particularly powerful when looking for patterns such as price manipulation in an RFQ environment. These capabilities enable clients to keep track of dealers who consistently offer “bad” prices relative to the composite, allowing venues to profile the behaviour of different dealers. This can be done at the dealer level or quote pricing engine level.
Nevertheless, there are many fixed income products for which there is no composite pricing feed. So the question becomes, how can we spot outliers where there is no point of reference? Finally, to add to the challenges, tiering is yet another dimension to take into account to obtain sensible alerts and cut out the noise that would lead to false positives.
Ever important reference data
Fixed income surveillance requires accurate and in-depth reference data. In order to find a reference price for seldom-traded instruments, a similar, more liquid, type of instrument would need to be found. Price signals within that instrument could then be examined along with macroeconomic and sector news, and credit rating factors. What then becomes important is the comparison of the relationship between the less liquid and more liquid instruments. Overall, this is a much more sophisticated approach than is required for cash equities.
Forging new fixed income surveillance models
The updated European regulations require market operators and investment firms that operate a trading venue to report attempted market abuse, not only market abuse that materialised. To this purpose, they need to establish and maintain effective arrangements, systems and procedures aimed at preventing and detecting insider dealing (attempted or succeeded) and market manipulation.
A major aspect of this is to be able to adequately analyse data being fed into a surveillance platform for manipulation. To do this, surveillance firms should not attempt to map the distinctive equity surveillance model directly over to the FI markets. Instead, distinct models for surveillance, based on different products, venues and trading protocols should be implemented. Ultimately, compliance departments who understand their firm’s own lines of business should be encouraged to help define bespoke analytics and reports to help detect market abuse in line with their business model.