Date21 November 2014

Contact Helle Søby ThygesenDirect +45 3370 1092hst@dbmf.dk

File No 514/25Doc. No 528501-v2

M E M O

Updated

MiFID/MiFIR, level 2: Liquidity and size specific to the instrument for bonds

LiquidityOnly true liquid instrument should be considered as suchWhen introducing new rules on liquid instruments, proper calibration of li-quidity is a key factor in ensuring efficient markets. If a financial instrument is wrongly deemed as liquid, liquidity providers trading the particular instru-ment will be forced to comply with enhanced transparency rules compared to illiquid instruments and maybe an obligation to provide firm quotes. As a result of these rules, the liquidity providers will be exposed to undue risk and will most likely refrain from trading the instrument going forward result-ing in even less liquidity than before. If the rules imply that illiquid bonds are deemed liquid, it will compromise the Commission’s ambitions to building an efficient Capital Markets Union, where e.g. corporate bonds must play a sig-nificant role in increasing the depth of EU capital markets.

Step-wise approach is appropriate Even for liquid instruments, the proposed transparency rules and quoting obligations can be too extensive. Since the rules are comprehensive and far-reaching, the consequences can be devastating for liquidity, issuers, in-vestors and the real economy if introduced in one step (“big bang”). It would worthwhile to introduce a stepwise approach1, carefully investigating the impact of each step, before introducing the next step. It is far easier and much more responsible to correct a wrong step in a stepwise approach than to revitalise absent European bond markets which are dried out of liquidity due to the new rules imposed at once. Also in the US, which is a much more homogenous and developed market, it has been considered necessary to introduce new transparency rules through a step-wise approach in the con-text of TRACE.

No coverage ratioESMA has not proposed any thresholds for the components and proposes either professional expert judgement or a “coverage ratio”, i.e. x % of the traded volume is deemed liquid. We strongly oppose the “coverage ratio”. The “coverage ratio” is not appropriate since it will most likely result in illi-quid instrument being deemed liquid. Relevant thresholds should be appro-priately calibrated by professional experts.

1 The overall framework should be set from day 1 in order to ensure that markets can rely on a robust, predictable and consistent set of rules.

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IBIA vs. COFIANSA recommends IBIA for bonds, alternatively COFIA IF adequate subclasses can be constructed and IF size specific to the instrument reflect retail size level for SI purpose. If COFIA is used for bonds without adequate subclasses, it is likely that instruments will be labelled as false liquid with detrimental consequences. At least the following subclasses should apply if COFIA is chosen:

Homogeneous risk characteristics for each sub-class Currency Credit quality distinguisher Open or closed for tap issuing

Recommendations for liquidity calibration IBIA for bonds or COFIA IF adequate subclasses and IF size specific

to the instrument reflect retail size level for SI purposes. No coverage ratio, the relevant threshold should be set by profes-

sional experts Average frequency of transactions should be a combination of min-

imum number of transactions within a specific time period and the minimum number of days on which at least one transaction occurred (option 3).

Average size of transactions should be a combination of total turnover over a period divided by the number of transactions and the total turnover over a period divided with the number of trading days during that period (new “option 3”).

Data related to market participants should be linked to the criterion for liquid markets: ..”.. a market where there are ready and willing buyers and sellers on a continuous basis.”. A number less than #end-sellers AND #buyers active should imply an illiquid market in that particular instrument

In concrete figures, the gross sample of potential liquid instrument should as a minimum be based on a combination of scenario 5 and 6 in DP, table 15, page 127:

o There should be at least 2400 trades during 1-year period (10 trades a day with 20 trading days per month) per ISIN

o The instrument should be traded at least on a daily basis per ISIN

o Based on the scenarios, the average daily volume should be at least 10 mm EUR per ISIN. However, in order to en-sure adequate volume, we suggest an average daily volume should be at least 100 mm EUR.

An example of liquidity calibrationESMA has proposed various components to be used in determining whether an instrument is liquid. The NSA has identified a gross list with data from NASDAQ (October 2013 - September 2014) with instruments (Danish mort-gage bonds at ISIN level with an issue size more than 5 bn DKK) that could be relevant to consider based on their turnover and number of trades. The

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list (containing 135 ISINs) has been used to calculate the components asked for by ESMA.

We observe the following:

A considerable share of the ISINs has no or very limited activity 58 ISINs (43% of the sample) have more than a yearly turnover of

2.4 bn EUR In a considerable share of the ISINs, the turnover is bunched to-

gether in connection with the time of issue. Less than 10 % of the 58 ISINs have an average daily volume of at

least 100 mm EUR Approximately 50 % of 135 ISINs have less than 200 trades per

month:o 4 ISINs complies with the criteria above if average volume is

at least 100 mm EURo 26 ISINs complies with the criteria above if average volumes

is at least 10 mm EUR

So it is not adequate just to take i.e. one parameter like the issue size into account for liquidity calibration. It is crucial to investigate other, relevant parameters as illustrated in the example to ensure that only true liquid in-struments are deemed liquid.

Size Specific to the Instrument (SSTI)The size specific to the Instrument (SSTI) serves several purposes:

It is the threshold (“upper limit”) for Systematic Internalisers’ (SI) firm quotes

It serves as a waiver for liquidity providers and applies in request for quote and voice trading systems

It serves as a threshold for post trade deferral (no requirement on trading systems)

When determining the threshold, it is critical to take notice of MiFIR art. 9 (b) and 9 (5) (d) (ii) and thereby take into account whether liquidity providers are able to hedge their risks and where a market consist in part of retail in-vestors, the average value undertaken by retail investors. Retail order size – either real or constructed – is key to use and not the normal market size, since this size will be very large due to the wholesale characteristic of the non-equities markets. SSTI should not be measured as a percentage of the Large in Scale size (LIS) as suggested by ESMA since these have very differ-ent aims. In this context it is relevant to refer to the co-legislative process, where the European Parliament identified EUR 100.000 as the threshold for pre trade transparency. NSA supports a SSTI threshold of EUR 100.000, which is also equivalent to the minimum threshold in the prospectus direct-ive.

Differentiate between pre- and post SSTI?

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It could be considered to introduce diversified levels of SSTI depending on whether it is aimed for pre- or post-trade since pre trade transparency risks are greater than post trade transparency risks. SSTI for pre-trade purposes should be the lowest threshold.

The larger the SSTI, the larger the risk Today, liquidity provider’s quotes are typically tailored for a specific client, taking in a range of factors, rather than being a statement to the market. This will change with the SI regime and the threshold for firm quotes (SSTI) must reflect this change. If SSTI is higher than proposed by NSA, the market risk will increase and quickly become significant due to the exposure if sev-eral clients utilise the firm quotes. For smaller countries with own currency, there is an additional currency risk since SIs often need to hedge in e.g. Ger-man bund futures. Furthermore, if the SSTI is higher than the proposed amount there will be SIs’ who will have to refrain from taking on this obliga-tion due to the risk. The result is fewer SIs and lower liquidity. It has been argued that the SI can say no to providing quotes. However, that is not an option for SIs. If clients cannot count on the SI quotes, the SI will face a con-siderable reputational risk which will negatively affect (other parts of) the SI’s business.

Recommendations for size specific to the instrument SSTI must reflect retail order sizes and should be set at EUR 100.000

which is also equivalent to the minimum threshold in the prospectus directive

It can be considered to differentiate pre- and post SSTI, where pre- SSTI must be the lowest threshold