The definition of liquidity in the fixed income market has become a controversial subject under the proposed MiFID II regulations, covering financial markets in Europe, as certain pre-and post-trade requirements will come into force for only liquid instruments. The Investment Association, which represents UK investment managers, has analysed bond trading data and made a recommendation to European regulators.

The European Securities and Markets Authority had suggested two possible measures for measuring bond liquidity under MiFID II. The proposed instrument by instrument approach (IBIA) measures bond liquidity on a case-by-case basis, and continually measures bonds as they trade in the markets. The alternative class of financial instruments approach plus (COFIA+) classifies bonds into groups, such as sovereign or corporate, and measures liquidity by the size of issuance.

Daniel Godfrey, chief executive of The Investment Association said in a blog yesterday that the group analysed bond trading data from electronic platforms last year and found the IBIA approach was flawed as liquidity in a single bond is episodic and disappears after a few weeks after issuance.

Godfrey said: “European regulators now have the data to justify adopting COFIA +.”

Richard Metcalf, director of regulatory affairs at The Investment Association, told Markets Media: “ After analysing the data we found that the broad brush approach of defining some aspects of liquidity by the class of bond works best, provided you also distinguish between the period immediately following issuance — two weeks in the case of corporate bonds — after which liquidity generally falls away.”

The association said the data showed that bonds can reasonably deemed to be liquid for issues larger than than €2bn for corporates and €5bn for sovereigns.

“The optimal thresholds of liquid bonds defined as an issue of more than €2 bn for corporates and €5bn for sovereigns covers well over half the market but can be tweaked as necessary,” added Metcalf. “The rest of the market can be covered as necessary by the large-in-scale waiver or the waivers that are specific to an instrument.”

The data has been provided to Esma who will be deciding on the definition of bond liquidity. “We have had an excellent dialogue over many years and will await the outcome at the end of September,” Metcalf added.

The Investment Association consulted with its members who are more than 200 UK investment manager, managing more than £5 trillion, and also the sellside.

In February a group of asset managers, including BlackRock, Fidelity and Vanguard wrote a letter to Steven Maijoor, chair of Esma, and said it is highly challenging to apply the MiFID regime to non-equity instruments, particularly  when determining bond market liquidity. The letter said: “Bond market activity is not predictable by looking back to the previous period while market events drive the peaks and troughs of liquidity of individual bonds.”

The majority of market participants felt the IBIA approach would best reflect the idiosyncrasies of bond market liquidity but the COFIA approach has the principal merit of being operationally simple. “We suggest that this framework can be further developed, within the constraints of the Level 1 text and without radical changes to the COFIA parameters that ESMA proposed in its Consultation Paper on the draft RTS of 19 December 2014,” said the letter.

The letter recommended that Esma considers adjusting the liquidity calibration to more accurately reflect the liquidity of the instrument; considering solutions for request-for-quotes systems to balance the objectives of transparency and market efficiency; and re-calibrating the pre- and post-trade transparency waivers and deferrals within each class of instrument.

“Our solution would have captured 86% of the overall bond market by value as liquid over the 12-month period from January 2014 – December 2014, achieving a similar outcome to ESMA’s proposal (93%), but minimising the misclassification of bonds,” added the letter. “As such, it continues to provide a comparable level of transparency to Esma’s proposed approach and does not deviate from the requirements of the Level 1 text.”

Maijoor told the Economic and Monetary Affairs Committee European Parliament at a MiFID II/MiFIR scrutiny hearing today that different groups of stakeholders are split on whether the COFIA or IBIA approach is best for defining bond liquidity. He said: “We have worked, over the last few weeks, on both options in order to find the right balance between accuracy, predictability and cost-efficiency which will be the main principles guiding the final decision of the Esma Board.”