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Today’s diverse markets can feel vast and complex. From developments in the voice, electronic and algorithmic execution landscape to the impact of regulation on liquidity, our Market Structure team can help you to cut through the noise.
Through monitoring, analyzing and commenting on the emergence of trends and the advancement of major initiatives across global markets, the team is able to provide you with insights and perspectives on the evolving marketplace.
Meridy Cleary Hi, I'm Meridy Cleary from J.P Morgan, and welcome to Market Matters. In today's episode with FICC market structure, we'll be discussing some of the regulatory initiatives and microstructural developments on our radar, which could shape market liquidity in the fixed-income, currency, and commodity markets. ESMA's final report on Organized Trading Facilities, liquidity dynamics post-Brexit, US treasury market structure report, and digital assets are all at the forefront in our conversations today.
And I have with me Kate Finlayson, who runs J.P Morgan's FICC market structure efforts globally. As well as Barnaby Hodgkins, who is an associate on the team.
Thanks, Meridy. Great to be here.
It's great to have you guys. So Kate, given the scope of fixed income currencies and commodities, we obviously cover quite a large amount of topics and themes. How do we gauge the relevance of different themes for our clients?
Well, Meridy, we're interested in microstructural developments, what execution trends are emerging, what is shaping how market participants interact and access liquidity, and we're also focused on the more macro view and what regulatory initiatives are coming to the fore that could have a bearing on market liquidity, and how do these translate into a business context for our clients.
So one of those regulatory initiatives we've been focusing on this quarter is the final report that ESMA published on April 8th in relation to Organized Trading Facilities. Kate, as a starting point, could you give us some background and tell us why this is important?
So this report, which forms part of the larger MiFID II review, hasn't necessarily been front and center for buy-side market participants, as it ostensibly relates to trading venues which have previously been associated more in the inter-dealer space. The report, which follows a consultation in September of last year, amongst other areas considered what activity constitutes a multilateral system and therefore should register as a trading venue.
Interesting, and how could ESMA's final report impact the day-to-day business of J.P. Morgan clients?
Where we get particularly interested is where certain technology providers and solutions are swept up by the rather broad definition of what constitutes multilateral activity. As we see some innovation and nascent solutions around execution management systems, order management system functionality, start to make strides in fixed income and allow our clients to attain certain execution efficiencies, to the extent that some of these solutions, whether they're developed in house or accessed through third-party providers, might be required to register as a trading venue in the future, what does that mean for our clients and additional costs associated with that?
That being said, it's important to note that ESMA recognized that given the variance in solutions out there, and it certainly isn't a cut-and-dried issue, ESMA has proposed that these firms are considered on a case-by-case basis. ESMA also points to potential further industry engagement on the topic, which will be important. I also think it's worth noting that this look at the trading venue perimeter is not necessarily only a European focus, with US regulators also looking at what constitutes electronic trading and the parameters for registration on certain platforms.
So you say that the ESMA report has gone a little under the radar. A topic that has been firmly on the radar for some time now is the impact of Brexit on liquidity. In our Q1 global insights publication of this year, the FICC Market Structure team focused on the derivatives market dynamics after the end of the transition period. Barnaby, what impact has the lack of equivalence had on the execution landscape, and what other dynamics are at play here?
Thanks, Meridy, absolutely. We're approaching the five-year anniversary of the Brexit vote, and I think we probably all hoped that January the 1st would have brought an end to this conversation or drawn a line in the sand perhaps. However, the impacts of Brexit on market structure will actually likely play out over a series of months, if not even years.
To start, and as you mentioned, you have that very well-documented impact in terms of execution. A lack of trading venue equivalence and market participants' regulatory requirement to adhere to their respective EU or UK derivatives trading obligation created that very tangible day one event, the trading volume shifting to EU venues and US swap execution facilities, as we noticed in our Q1 global insights publication.
However, while this impact's been getting a lot of attention in the news, we, and indeed a lot of the clients we speak to, suggest that the relatively seamless transition of trading across UK, EU, or US venues has actually illustrated how flexible the global derivatives markets actually are. We of course still view trading venue equivalence as an optimal future state, but the market certainly demonstrated its ability to adapt in this time.
So now, arguably, a more significant impact of Brexit on market structure is actually the clearing landscape, beyond the temporary equivalence that's been granted to UK CCPs until June of next year.
Absolutely. You're right, Barnaby. At the start of this year, the European Commission issued a communication reiterating its commitment to strengthening the EU's financial infrastructure, which includes shifting Euro-denominated clearing by EU entities to the EU. However, as it stands, Euro liquidity is still fairly skewed towards London and LCH, with our Q1 report highlighting that as much as 90% of Euro-denominated clearing still sits in London.
There are, of course, a number of factors at play, from liquidity dynamics at the different clearing houses, to the pending finalization of the Location Policy under EMIR 2.2. But just as the industry is perhaps keen to avoid a forced relocation scenario, and EU entities may wish to be able to retain the element of choice with respect to clearing venues, there is the view that a gradual shift may take place organically. Let's take the pension fund clearing exemption as an example.
So as it stands, and without any further extension, this segment would have to find a solution for variation margin ahead of June 2023. If European clearing houses can assist in finding these solutions, or help pension fund clients through the transition, is it possible you could see a natural flow to the continent? That's certainly a possibility.
I completely agree with that, Kate. And I think that message even extends to a third impact of Brexit, which is the future of portfolio management, in particularly, the use of delegation to third-country entities. This is particularly relevant, given the recent review of the Alternative Investment Fund Management Directive, or AIFMD. European Commission is focused on ensuring that fund management entities within the EU are not simply letterbox entities.
And so there's a question about substance in relation to the portfolio management of EU investor money. While we still await the results of this review from earlier in the year, the current delegation framework enables portfolio managers to manage funds from theoretically anywhere in the world. Indeed, it's this framework that permits a European saver to get unfettered access to the best portfolio managers across different markets and asset classes, all with relative ease. And from what we hear and see, like their sell-side counterparts, there's third country fund managers that have already established, or are certainly considering establishing, an office in the EU already. To that end, like the clearing piece that Kate mentioned, you could suggest that some of the migration might happen naturally. However, there's still very much a lot of this in flux, and we certainly wouldn't want to speculate until we have sight of the final European Commission report.
It's certainly an area we haven't heard the last of, Barnaby. So now looking at the States, we know that the U.S. Treasury market has been in the headlights recently, as regulators take into account the period of pronounced market volatility, at the onset of the pandemic last March. Nelly Liang, who is a fellow at the Brookings Institute, published a paper late last year on enhancing US Treasury market liquidity in times of stress, and put forward some proposals, including a standing repo facility, wider central clearing, and less binding leverage constraints, with the aim of increasing the resilience of the US Treasury market in both normal periods and in periods of volatility.
Definitely, and of course, Nellie Liang has been nominated as Undersecretary for Domestic Finance at the US Treasury Department, which has jurisdiction over issuance strategy in the 21 trillion dollar treasury market. It's clear that Liang is vocal about her views in enhancing a structure of US treasury market, and may prioritize some of these proposals in her new position. Liang is not alone, of course, at the recent Federal Reserves Primary Dealers meeting, Brian Smith, who's Deputy Assistant Secretary for Federal Finance, highlighted the proposals of the inter-agency working group on treasury market surveillance. And that working group has set out five key areas of consideration, which includes a focus on data quality and availability, trading venue transparency and oversight, evaluating the extent to which expanded central clearing would promote or inhibit liquidity provision and healthy market functioning, and what potential changes to regulation could promote resilient liquidity provision, during future periods of market stress.
So there's a lot of focus on money markets right now. And we are, of course, also cognizant of the fact that the supplementary leverage ratio carve-outs put in place last year as a result of the market facility have expired. While the US global systemically important banks have a substantial buffer in place, it becomes a question of timing for some of these reviews, particularly around liquidity provision and any structural changes to the SLR.
Yeah, and we'll definitely be keeping an eye out for those structural reviews when they're made available. So, another hot topic given the growing adoption of block chain and DLT is that of digital assets. Particularly in the last few weeks, we have seen more activity around Central Bank Digital Currencies, or CBDCs, with China moving forward with their pilots on its digital yuan. So, Barnaby, should we anticipate the adoption of a digital dollar, or a digital pound?
So, I think we could probably do an entire podcast on the growing topic that is digital finance. And I'm sure, who knows, maybe in the coming year we'll do just that. But to start, and as you allude to, Meridy, for us it's clear the debate on CBDCs is just getting going. 2021 has already been a formative year, from the pilot you mentioned by the People's Bank of China, to new digital tasks force for the euro and pound, and even in the US, that Chairmen Jerome Powell has started to suggest that they're warming to the idea. You're clearly seeing global governments and central banks begin to appreciate the digital forms of money issued using distributed leisure technology is no longer a fad, but potentially a realistic future state.
That being said, the decisions are complex. And there's a number of trade offs, which central banks need to study carefully. And it's important to have a clear idea of the central bank's objectives and in the problems that the CBDC is trying to solve. Nevertheless, and for us, as a market structure team, what remains incredibly interesting is how these CBDCs are expected to integrate or work alongside the existing infrastructure, stable coins, or crypto currencies, which I'm sure our listeners are aware are becoming increasingly difficult to ignore. While the likes of bitcoin, Ethereum, and even the stable coins in circulation, like tether, or USDC, may have started as genuine payment solutions, one can now argue that they've transformed into tradable and highly volatile investment products. Therefore, as these two similar, but also very different digital assets develop in parallel, what we're interested to know is how will their relationship look.
Actually, this relationship between regulator, CBDCs, stable coins, and crypto will be a fascinating one to monitor over the next couple of years. In the US we've seen Gary Gensler sworn in as the chairman of the SEC. In his most recent teaching post at MIT, he led classes on cryptocurrencies and digital finance, which indicates this is an issue in which he could be happy to engage and could add some momentum. Perhaps what's most interesting, beyond Bitcoin, or cryptocurrencies, is the infrastructure underlying it all. I think distributor ledger technology and the benefits that could be derived from advancements in this space will be a key focus. We've seen the initial use of blockchain for entry day repo, which reflects the ability of blockchain to create solutions that help mobilize assets in short periods of time, streamline settlements and reduce operational inefficiencies, as well as entry day liquidity costs. So what this development could mean for broader use in securities and beyond is particularly exciting.
Agreed. It's so exciting to be covering these pertinent topics and themes that are constantly evolving. We've discussed a trading venue parameter, the ongoing effects of Brexit, and the future of digital assets. But this is just the tip of the iceberg in terms of the topics covered by our team. We publish thought leadership pieces and actively engage with our J.P. Morgan clients on a range of themes. So with that, thank you for so much Kate and Barnaby, for sharing your insights with us today. And to our listeners, please stay tuned for more episodes of Market Matters. I hope you have a great day.
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