How Has MiFID II Fundamentally Altered the Economics of Market-Making in Corporate Bonds?

Concept

The Markets in Financial Instruments Directive II (MiFID II) represents a fundamental rewiring of the European financial market’s operating system. For the corporate bond market, this directive was a catalyst for a profound alteration of its core economic principles, particularly for market-making. The pre-MiFID II environment for corporate bond trading was characterized by a significant degree of opacity.

Price discovery was often a bilateral and private affair, with liquidity concentrated among a select group of dealers. This structure, while functional, created information asymmetries and made it difficult for investors to verify best execution.

MiFID II introduced a new paradigm of transparency, mandating extensive pre-trade and post-trade reporting requirements. This directive compelled market participants to disclose quotes and executed trades to the public, albeit with certain delays and waivers for less liquid instruments. The intention was to create a more level playing field, where price information is more widely disseminated and accessible. This shift has had a direct impact on the profitability and risk management practices of market-makers.

The increased transparency has compressed bid-ask spreads, as the ability to profit from informational advantages has diminished. Market-makers are now operating in a more competitive and scrutinized environment, where their pricing strategies are subject to constant public evaluation.

The introduction of MiFID II has fundamentally recalibrated the risk-reward equation for market-makers in the corporate bond market.

The directive also introduced the concept of Systematic Internalisers (SIs). SIs are investment firms that, on an organized, frequent, systematic, and substantial basis, deal on their own account when executing client orders outside a regulated market, a multilateral trading facility (MTF), or an organized trading facility (OTF). This formalization of a previously less-regulated activity has brought a new level of competition to the corporate bond market. SIs are now a recognized part of the market structure, with their own set of reporting and transparency obligations.

This has created a more fragmented market landscape, with liquidity now dispersed across a wider range of venues and participants. Market-makers must now navigate this more complex ecosystem to source liquidity and execute trades efficiently.

Furthermore, the unbundling of research and execution fees has had a significant impact on the traditional business model of sell-side firms. Previously, research was often provided as part of a bundled service, with the cost implicitly covered by trading commissions. MiFID II’s requirement for explicit payment for research has forced a re-evaluation of the value proposition of sell-side services.

This has led to a more discerning approach from the buy-side, who are now more selective about the research they consume and pay for. For market-makers, this has meant a reduction in a traditional source of revenue and a greater emphasis on the quality of their execution services as a key differentiator.

Strategy

In the post-MiFID II era, market-makers in the corporate bond market have had to adopt new strategies to remain profitable and competitive. The old model of relying on wide bid-ask spreads and informational advantages is no longer viable. Instead, market-makers are now focusing on a combination of technological innovation, sophisticated risk management, and a deeper understanding of market microstructure. The strategic imperative is to find new sources of alpha in a more transparent and electronified market.

One of the key strategic shifts has been the embrace of data and analytics. The increased availability of post-trade data, while not yet perfect, provides a rich source of information for market-makers. By analyzing this data, firms can gain insights into trading patterns, liquidity dynamics, and pricing trends. This allows them to develop more sophisticated pricing models and risk management strategies.

For example, market-makers can use data to identify which bonds are likely to be more liquid and adjust their pricing accordingly. They can also use data to monitor their own performance and identify areas for improvement.

How Has Technology Reshaped Market Making Strategies?

Technology has become a critical enabler of the new market-making strategies. Algorithmic trading, once the preserve of the equity markets, is now becoming more prevalent in the corporate bond market. Market-makers are using algorithms to automate their pricing and hedging processes, allowing them to respond more quickly to market movements and handle a larger volume of trades.

This has led to a more efficient and scalable market-making operation. However, the development and maintenance of these systems require significant investment in technology and quantitative talent.

The following table illustrates the strategic shift in market-making operations pre- and post-MiFID II:

What Is the Role of Relationship Management in the New Environment?

While technology has become more important, relationship management remains a key part of the market-making business. In a more fragmented and competitive market, the ability to build and maintain strong relationships with clients is more valuable than ever. Market-makers who can provide their clients with value-added services, such as market color, research, and access to liquidity, will be better placed to succeed. This is particularly true for the less liquid segments of the corporate bond market, where relationships and trust are still paramount.

The following list outlines some of the key strategic considerations for market-makers in the post-MiFID II environment:

• Technology Investment ▴ A commitment to investing in technology is essential to remain competitive. This includes developing or acquiring algorithmic trading capabilities, data analytics tools, and connectivity to multiple trading venues.
• Data Strategy ▴ Developing a clear data strategy is crucial. This involves not only collecting and storing data but also having the analytical capabilities to extract valuable insights from it.
• Risk Management Framework ▴ A robust risk management framework is necessary to navigate the more complex and fast-paced market environment. This should include real-time monitoring of positions and risk exposures.
• Client Segmentation ▴ A one-size-fits-all approach to client service is no longer effective. Market-makers need to segment their clients based on their needs and trading styles and tailor their services accordingly.

Execution

The execution of market-making strategies in the post-MiFID II corporate bond market requires a high degree of precision and operational efficiency. The theoretical strategies discussed previously must be translated into concrete actions and workflows. This involves a combination of sophisticated technology, skilled personnel, and a deep understanding of the regulatory landscape. The focus on best execution under MiFID II means that every aspect of the trading process is under scrutiny.

A key aspect of execution is the choice of trading venue. Market-makers now have a wider range of options, including regulated markets, MTFs, OTFs, and SIs. Each venue has its own unique characteristics in terms of liquidity, transparency, and cost.

The decision of where to execute a trade will depend on a variety of factors, including the size of the order, the liquidity of the bond, and the client’s instructions. Market-makers need to have the connectivity and the smart order routing capabilities to access multiple venues and find the best possible price for their clients.

Effective execution in the current environment is defined by the ability to seamlessly integrate technology, data, and human expertise to navigate a fragmented market structure.

How Does Algorithmic Trading Work in Practice?

The implementation of algorithmic trading strategies requires a sophisticated technological infrastructure. This includes a high-performance trading engine, low-latency connectivity to trading venues, and a robust data management system. The algorithms themselves can range from simple price-quoting engines to more complex strategies that incorporate machine learning and artificial intelligence. The goal of these algorithms is to automate the trading process, reduce operational risk, and improve execution quality.

The following table provides an illustrative example of the impact of algorithmic trading on market-making performance:

What Are the Key Compliance Considerations?

Compliance is a critical aspect of execution in the post-MiFID II world. Market-makers need to have robust systems and controls in place to ensure that they are meeting all of their regulatory obligations. This includes pre-trade and post-trade reporting, best execution monitoring, and record-keeping. The compliance burden is significant, and firms that fail to meet their obligations can face substantial fines and reputational damage.

The following list outlines some of the key compliance tasks that market-makers need to perform:

• Transaction Reporting ▴ All trades must be reported to the relevant competent authority in a timely manner. This requires a robust reporting infrastructure and a deep understanding of the reporting requirements.
• Best Execution Monitoring ▴ Market-makers must be able to demonstrate that they have taken all sufficient steps to obtain the best possible result for their clients. This involves monitoring execution quality on an ongoing basis and making adjustments as necessary.
• Record-Keeping ▴ All relevant records, including trade data, communications, and best execution policies, must be kept for a minimum of five years. This requires a secure and scalable data storage solution.

Reflection

The transition to the MiFID II regime has been a challenging one for market-makers in the corporate bond market. The new rules have required significant changes to business models, technology, and compliance processes. However, the directive has also created new opportunities for firms that are able to adapt and innovate.

The market is now more transparent, efficient, and competitive than ever before. As the market continues to evolve, the ability to leverage technology, data, and relationships will be the key to success.

The journey towards a more electronic and data-driven market is far from over. New technologies, such as artificial intelligence and distributed ledger technology, have the potential to further transform the corporate bond market. Market-makers who are able to embrace these new technologies and adapt their strategies accordingly will be well-positioned to thrive in the years to come. The future of market-making in the corporate bond market will be defined by a continuous process of innovation and adaptation.