Confusion reigns over Mifid transparency in forex

A carve-out from Europe's new trading transparency regime for foreign exchange products has left dealers and end-users confused. Banks say they may still have to disclose quotes to clients upon request.

On September 28, the European Securities and Markets Authority (Esma), released the final level 2 regulatory technical standards (RTS) for the second Markets in Financial Instruments Directive, and its related regulation Mifir. The RTS deems forex products to be illiquid – reversing the stance taken in the first RTS, which found them to be liquid – and effectively exempts them from Mifid II's controversial transparency requirements.

However, banks point to an apparent conflict with Mifir's level 1 text, which requires 'systematic internalisers' – banks that execute client orders outside regulated markets above a certain market share threshold – to disclose quotes for illiquid products to clients on request.

"There is acute uncertainty around who exactly you should provide a quote to," says a source at an industry body. "We would hope that clarification eventually emerges from regulators in the context of level 3."

The requirement to disclose quotes on request is found in article 18(2) of Mifir and applies to all illiquid bonds, structured finance products, emission allowances and derivatives. The rule was designed to provide transparency for illiquid products.

There is acute uncertainty around who exactly you should provide a quote to

However, dealers say forcing transparency in an illiquid product will make it impossible for hedgers to transact without revealing their interest to the market.

"Everyone's speaking to lawyers but some people have come back saying they don't really know what this means; there are about 20 different views on it," says the head of regulation at a UK bank. "If you are providing quotes to clients and if a client happens to call up and ask for that quote, then you have to disclose it to them – although you don't have to execute on it. If something happens in the market, the likelihood of a client calling us up to get a quote on a three-month forex forward – a highly traded product – is quite high. The jury's out on what that means."

One concern is that disclosure could damage client relations – for instance, if one customer discovers it is receiving less favourable quotes than its peers.

Dealers are still trying to figure out the implications of the latest RTS and there are plenty of unanswered questions.

For instance, although all forex products are deemed illiquid, the RTS still provides exemptions for so-called large in scale (LIS) and size specific to the instrument (SSTI) transactions above a certain threshold. The industry has been left wondering why Esma provided these exemptions for products that are illiquid and therefore not subject to the transparency requirements in any case.

"I think you need a very large piece of paper to write down all the areas where the RTS caused more confusion than it addressed. But this issue seems like a prime candidate," says the source at the industry body. "On the one hand, Esma takes forex out of scope for transparency requirements, but on the other hand it acts as though forex is still in scope."

An Esma spokesperson provides an explanation for this: the waivers for large trades above a certain threshold exist to provide relief in cases where a national regulator decides to apply the transparency requirements to illiquid products, as is their right under the Mifid II legislation.

"It would legally and technically be possible for national competent authorities to require transparency on these illiquid products, but this is extremely unlikely to ever happen in reality," says the Esma spokesperson. "All forex products being deemed illiquid for the time being is of course an assessment on today's data, so this will be reviewed at a later stage, probably in 2016 when there is new data. And then of course the outcome may be different."

Steve Baseby, associate policy and technical director at the UK's Association of Corporate Treasurers, warns against treating the illiquidity determinations as permanent relief.

"Corporates would still need to prepare as though these rules were in operation and so an apparent temporary respite may not have any meaningful effect," says Baseby.

Esma granted the relief in part due to concerns about the quality of the data used to assess the liquidity of certain products. The regulators initially found all forex products to be liquid in its February 2015 consultation paper, but the data used to support that determination was questioned, with one source referring to it as "garbage".

Esma acknowledged those concerns in its latest RTS, noting that the data available did not allow for a "comprehensive and undistorted" analysis of the liquidity of forex derivatives. As a result, all forex derivatives were deemed illiquid pending the availability of better data, which could trigger a revision of the RTS.

A senior treasurer at a non-financial corporate in Germany says data quality issues have undermined Esma's liquidity determinations across all asset classes.

"Given that all the data is a mess they should have dismissed the transparency issues for all classes for the time being. We've merely bought time for forex. However, we hope it will take a lot of time to sort out the data mess. What a bitter irony that the only part of Emir we always found convincing – increasing market transparency through trade reporting – is now the one we want to see completed last to limit the damage to our daily treasury business via Mifid II," he says.

This article first appeared on Risk.net.