Liquidity definition proving to be problematically fluid
Just as US Supreme Court Justice Potter Stewart famously defined the threshold test for obscenity, “I know it when I see it”[1], liquidity is proving slippery to define. ESMA Chairman Steven Maijoor recently echoed the description, saying that liquidity lends itself better to recognition than definition. ESMA is in the process of defining illiquidity by asset and sub-asset class, in order to apply MiFID II Trade Obligation exemptions[2] . MiFId II and MiFIR take different approaches as to what constitutes a liquid market, and neither have much in common with EMIR or International Financial Reporting Standards. Section 3.6 of ESMA’s recent discussion paper sketches a basic framework for MiFIR’s approach to a liquidity measure:
- Average frequency of transaction. Minimum number of transactions + a minimum number of traded days
- Average transaction size. Number of transactions adjusted for total turnover / trading days
- Number and type of market participants. “Market Participant” – any member of a trading venue involved in at least one transaction in the relevant market
- Average size of spreads. End-of-day relative bid-ask spreads in the most liquid market
MiFIR has no prescription as to the combination of the above “criteria” or any definition as to whether a given instrument, or asset class, is “liquid”. It is no surprise that ESMA has appealed to market participants for help,
“Esma has not been able yet to analyse liquidity and propose thresholds for the derivatives universe in particular but is conscious that such thresholds… have to be proposed in time for the Esma consultation paper on technical standards, which will have to contain concrete legal drafting.”
Definition is only one half of ESMA’s problem, Maijoor notes “Esma also faces the operational challenge of getting hold of high-quality data per asset class which allows for a precise calibration of thresholds.”
As the term implies, liquidity is a fluid reality subject to multiple, dynamic variables and hence, highly resistant to precise definition. Attempting such definition is market-regulatory terra incognita and, for all its challenges, is merely the first step to meaningful transparency. For example there is, to date, no attempt in any regulation to quantify the relationship between solvency and liquidity. The exact liquidity definition will have critical implications for the overall coherence and second-order consequences of the whole MiFID II/MiFIR project. The balance between legal precision and opening the floodgates to gaming the system may prove hard to find. Whatever the final formulation, it seems clear that the rules will impose yet another layer of complex compliance metrics, with attendant costs in systems and personnel. The comment period ends on 1 August 2014, ESMA is required to draft the resulting consultation paper by the end of the year.
[1] Justice Potter Stewart, concurring opinion in Jacobellis v. Ohio 378 U.S. 184 (1964), regarding possible obscenity in the film “The Lovers”.
[2] Article 28 MiFIR specifies that “sufficiently liquid” trades between FCs and certain NFCs may not be bilateral and must be conducted via an approved trading venue.
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