Will CSDR create a small cap liquidity crisis?

In our last blog, which explored the rise of request-for-quote (RFQ) offerings in equities, I mentioned that MiFIDII had some unintended consequences resulting in a shift in market liquidity profile. One of the main tenets of MiFIDII was to increase the volumes traded on lit venues, with dark volume caps introduced and crossing networks banned, it seemed like shift to lit was inevitable. However, as we now know from published figures over the last two years, trading on lit markets has declined since MiFIDII.

Figures show a significant decline in lit venue execution volumes across Europe post implementation, whilst off exchange trading in size has increased as have SI volumes. Since this much volume does not simply disappear, it could be extrapolated that orders are being bulked up and traded in the dark to remain large in scale and to avoid the volume caps, rather than being placed on exchange. The rise in ETPs has seen a push to end of day benchmarking increasingly driving closing auction volumes to new highs, whilst intraday auctions fade away.

Whilst MiFIDII drove behavioural changes, it wasn’t those intended.

So, whilst MiFIDII drove behavioural changes, it wasn’t those intended. Hence we now have the pleasure of an ESMA Consultation into MiFIDII Dark Volume Caps and Trading Obligations.

The Central Securities Depository Regulation (CSDR), though now delayed until early 2021, is on the horizon and will increasingly be a focus for firms as this year progresses. What unintended consequences will it bring? And what can be done to make sure that these consequences do not hamper efficient market operation?

CSDR has an admirable aim: to drive down the level of settlement failure and improve the operational efficiency of the market, subsequently protecting end investors. Mandatory buy-ins and compensation will be introduced to ensure that it’s extremely costly to fail, with the added intent being to make sure that short traders physically have the stock (or are sure it’s available to borrow) before shorting. However there are problems lurking at the less liquid end of the market.

At the lower end of the FTSE 350 and the AIM segment there are many instruments heavily supported by market making activity. Here, market makers take on risk to ensure these stocks are constantly priced and available to trade, bridging the time gap between less frequent investor activity.

They are bound by exchange rules to quote throughout the day and are therefore exposed to market sentiment. However, with much of the free float in these shares hidden and inaccessible, what happens when a market maker is driven to sell short and has to deliver? With nowhere to turn to borrow, they are at increased risk of settlement failure and the soon to be mandatory buy-in costs under CSDR.

Market Makers can’t afford to take on another risk burden as well as fines for conducting the activity they are bound to by exchange rules. Their options are few: switch to an agent role and cease making markets, or ensure there is a pool of sensibly priced liquidity to lean on when required.

So, whilst CSDR seeks to reduce settlement failure, its unintended consequence may well be to fracture the less liquid equity markets as market makers are forced to reconsider their supporting roles.

Whilst the technology exists to RFQ for a borrow price and volume, it’s not a solution if the volume simply doesn't exist. Founders, private investors, small cap funds and wealth managers need to engage in securities lending if this important end of the market is to survive. But, bilateral lending agreements are expensive to implement. Perhaps some form of CCP based lending support is required to operate a pool of available liquidity to sustain the market.

There is now slightly more time left before the CSDR implementation, but it will soon fly by. Many firms, and the financial press, are only just waking up to the danger for the less liquid markets; if CSDR is left unchanged, the unintended consequence may well be a small cap liquidity crisis.

This blog was written by:
Russell Thornton - Head of trading strategy at Iress