Panacea or Problem? In light of the ongoing review of the Markets in Financial Instruments Directive (MiFID II), this latest research from TABB Group investigates the potential impact of the review’s pre-trade transparency proposals on the fixed-income market, its participants and the real economy. TABB Group’s research on fixed-income markets illustrates an industry struggling under the weight of the current economic climate, a decline in risk appetite and concerns over impending regulation. This sentiment comes not only from banks and dealers, but also from institutional investors frustrated at their inability to find liquidity, companies frozen out of the debt markets, and sovereign issuers that are progressively becoming reliant on domestic investors as international financiers retreat. TABB Group, which was founded in 2003, is a global financial market research firm that conducts research based upon an interview-driven methodology. Our research for this report is gathered from comprehensive interviews with market participants covering a wide spectrum of investors (both institutional and retail), trading venues, market makers, as well as company and government issuers. In addition to the interviews conducted for this report, TABB has also drawn on other surveys conducted during the past six months regarding similar regulatory issues for the fixed-income market, which include a further 100-plus interviews. The majority of market participants interviewed expressed their concerns about the proposed regulation further hampering liquidity, increasing trading costs, and ultimately making it more difficult for issuers to raise capital and for investors to achieve the necessary yields over time. For this report, TABB Group examines the current structure of the debt markets and the increasingly important role they play in the wider economy. The study explains why debt markets are distinct and cannot be viewed in the same light as equity markets, and why they require different investment, distribution and trading structures. We then investigate the various types of debt trading structures, the notion that fixed-income markets are primarily institutional, the role of primary versus secondary market activity, and how the secondary market operates in relation to indicative pricing, firm quotes and actionable orders. The final section of the study looks at the regulatory changes proposed in MiFID II and the effects they will have on pricing, disclosure, order execution and the ability to raise capital.

Summary The majority of sovereigns do not post collateral to support their use of over-the-counter (“OTC”) derivatives1. As a result, dealers regularly have credit exposure arising out of these contracts which is often hedged with the sovereign Credit Default Swaps (“CDS”), and interest rate and foreign exchange swaps and options. This process has been of particular concern in Europe because of the possible ban on the use of sovereign CDS. To assist in highlighting this and other concerns arising out of the practice not to collateralize OTC derivatives, two associations2 (“the Surveying Associations” or ”SAs”) conducted a survey of dealers earlier this year, regarding their OTC derivatives exposure to European Sovereigns (“ES”).

Executive Summary It is often reported that the proportion of European equities trading that is over-the-counter (‘OTC’) is approximately 40%. Our analysis of market data demonstrates that this figure is incorrect and the proportion of equities trading represented by ‘real’ OTC trades is actually around 16%. The European equity market landscape has been transformed since the implementation of the Markets in Financial Instruments Directive (’MiFID’) in November 2007. New trading venues have been established and new execution techniques developed to compete for a share of the circa €1.7 trillion per month European equity market. The post-MiFID evolution of the European trading environment - from a few centralised platforms to multiple fragmented venues - has brought many benefits, but also uncertainty. One such uncertainty relates to the quality and utility of data on OTC trading. AFME has analysed data from the largest brokers in the European market covering equity trades reported as OTC under MiFID during the period from Q1 2008 to Q3 2010. According to our analysis, approximately 60% of all reported MiFID OTC equity trades in this period were actually duplicate trades already reported elsewhere. These are herein referred to as ‘OTC Reporting Events’- i.e. trades which must be reported under MiFID but are not true indicators of transaction volume. The remainder of OTC trades include actual transactions not reported elsewhere, herein referred to as ‘OTC Real Liquidity’. Our analysis shows that OTC Real Liquidity trades represented approximately 16% of all European equities turnover in the same period.