EU Equity pre- and post-trade transparency regulation (LBF vol. 21) 2021/18.III.2.3.1:18.III.2.3.1 Liquidity

EU Equity pre- and post-trade transparency regulation (LBF vol. 21) 2021/18.III.2.3.1

18.III.2.3.1 Liquidity

Documentgegevens:

mr. J.E.C. Gulyás, datum 01-02-2021

Datum: 01-02-2021
Auteur: mr. J.E.C. Gulyás
JCDI: JCDI:ADS266835:1
Vakgebied(en): Financieel recht / Bank- en effectenrecht
Financieel recht / Europees financieel recht
Financiële dienstverlening / Financieel toezicht

Liquidity is related to the market microstructure and macrostructure, two concepts that have both been examined above (see paragraphs 2.1-2.2).1 To start with the market macrostructure. On the one hand, the market-shaping philosophy prefers a concentrated market, based on the assumption that concentration supports liquidity. The idea is that concentration supports liquidity, since investors like to trade at the same time of the day and in the same venue as many others (‘liquidity begets liquidity’).2 By contrast, the market-led philosophy argues that fragmentation is not necessarily bad. Fragmentation can support competition. Competition can in turn reduce trading fees, enhance investor choice and innovation. The argument is that where liquidity becomes fragmented, liquidity can be made available through transparency and technology ‘gluing’ the fragmented liquidity together.3 In other words, the market-led philosophy argues that liquidity enhances due to the benefits of the competitive setting (lower trading costs, and so forth).4 The market-led and market-shaping philosophy can both have pros and cons in terms of liquidity outcomes. Equity pre- and post-trade transparency is important in both market philosophies, but gains momentum in the situation where liquidity fragmentation risks are bigger. Emphasis on equity pre- and post-trade transparency rules grows in a fragmented setting in order to ‘glue’ the dispersed liquidity together (see paragraph 2.2 above).5

In terms of market microstructure, when trading in a financial instrument becomes more liquid, the market microstructure naturally evolves to a system with little or no designated intermediaries providing liquidity by trading on own account. As noted above, the opposite is true for illiquid markets, which rely stronger on the provision of liquidity through designated investment firms (e.g. market makers).6Equity markets are often (not: always) associated with high levels of liquidity, which is reflected by trading through order-driven markets7 and in past years increasingly through closing auctions.8 Lower risks are apparent in these markets as to pre-trade data publication.9 Post-trade transparency risks are also more limited, given the reduced amount of designated investment firms providing liquidity by trading on own account (see paragraph 2.1 above). By contrast, non-equity instruments, such as bonds or derivatives, face sharper transparency risks, since thinner trading patterns are apparent.10

The EU acknowledges the differences between transparency risks for equity versus non-equity instruments (different asset classes). Already under the ISD more flexible transparency provisions were in place for non-equity instruments.11 Likewise, MiFID II makes a distinction between an equity and non-equity transparency regime.12 The foregoing does not mean that only non-equity instruments face liquidity risks. Trading in some equities can also be highly illiquid, in particular with respect to SME (small and medium-sized enterprises) shares and the shares of small capitalization (‘small cap’) issuers.13 From the ISD to MiFID II the EU has acknowledged transparency risks for illiquid equity instruments (different sub-asset classes), whether through permitting different market microstructures14 or exceptions for equity pre- and post-trade data publication (e.g. a lower threshold for deferral of equity post-trade data publication for less liquid instruments).15

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Liquidity is, in short, the ability to trade a financial instrument quickly at a price close to its consensus value. For a more detailed examination of the term liquidity, reference is made to chapter 1(section IV).

See in this context T. Foucault, M. Pagano, and A. Röell, Market Liquidity, Oxford University Press, 2014, p. 7.

See, for example, O’Hara and Ye, as well as Degryse, De Jong, and Van Kervel, who find that competition has benefitted overall liquidity due to competitive pressure to provide lower transaction costs and faster execution (source: Oxera, The design of equity trading markets in Europe, March 2019, p. 45).

See, for example, recital 5 MiFID I Implementing Regulation.

See D. Valiante, Setting the Institutional and Regulatory Framework for Trading Platforms: Does the MiFID definition of OTF make sense?, April 2010, p. 3.

N. Moloney, EU Securities and Financial Markets Regulation, Oxford University Press, 2014, p. 431.

Over the last few years, the proportion of shares traded during the closing auctions has increased steadily on all main European RMs, where it can exceed 40% of all trading. A closing auction is a traditional periodic auction, in short meaning it comprises a call phase (usually of roughly five minutes) during which orders are accumulated in the order book without immediately giving rise to a transaction The orders entered into the order book of the closing auction are then all executed (‘uncrossed’) at the same closing price at the end of the auction (ESMA, Consultation Paper: MiFID II/MiFIR Review Report, 4 February 2020(ESMA70-156-2188), p. 98). For a further examination of the growth in closing auctions, reference is made to chapter 5(section VII).

The reason there are lower pre-trade transparency risks in order-driven markets and closing auctions (periodic auctions) is because there is no requirement for investment firms to provide liquidity, in contrast with quote-driven markets (Annex 1, MiFIR Delegated Regulation 2017/587). The pre-trade transparency risks are ‘lower’, since common pre-trade transparency risks such as adverse selection (i.e. trading against a superior investor) and information leakage are still apparent. Reference is made to CEPS, MiFID 2.0: Casting New Light on Europe’s Capital Markets, 2011, p. 55-56.

10.

N. Moloney, EU Securities and Financial Markets Regulation, Oxford University Press, 2014, p. 431-2.

11.

Art. 21 ISD.

12.

The MiFID II equity transparency regime concerns shares, depositary receipts, ETFs, certificates and other similar financial instruments (art. 3 MiFIR). The MiFID II non-equity regime governs bonds, structured finance products, emission allowances, and derivatives (art 8 MiFIR).

13.

N. Moloney, EU Securities and Financial Markets Regulation, Oxford University Press, 2014, p. 432.

14.

D. Valiante, Setting the Institutional and Regulatory Framework for Trading Platforms: Does the MiFID definition of OTF make sense?, April 2010, p. 3.

15.

For example, SIs have only been required to publish pre-trade transparency in relation to (a) liquid shares; (b) up and until the average market size (art. 27 MiFID I and art. 14 MiFIR).