Looming fines for market makers threaten fresh City blow
HE arcane rules governing the plumbing of City trading aren’t usually pulseracing stuff. But changes looming into view next year and a new regime of big financial penalties are making a few hearts in the Square Mile beat faster.
The concern has been caused by new European Union regulations governing the settlement of trading in everything from shares to bonds introduced in the wake of the financial crisis.
Regulators aimed to harmonise the rules across Europe under a regime known as the Central Securities Depositary Regulations, which took effect in 2014. Belgium-based
Euroclear, for example, is the UK’s CSD, tracking transactions and allowing assets to be transferred between parties electronically.
Although the regulations have been around for five years, the bite in the new framework, “settlement discipline”, is soon to hit. From September 2020 all market participants will be subject to financial penalties for failing to settle trades in time.
Market makers, obliged to give a buying and selling price in specific stocks, are up in arms, particularly those like Peel Hunt and Winterflood dealing in a wide range of companies. While settlement works smoothly for highly traded stocks like Vodafone, soon market makers will face daily fines from CSDs if they fail to deliver on less-liquid stocks and bonds, and the threat of so-called mandatory buy-ins.
That’s when a market maker fails to deliver his shares on time, and the buyer appoints another agent to enter the market and get them at the best possible price to ensure delivery. If the price is higher, and it invariably is, the market maker is on the hook for the difference.
Market makers don’t own the shares in all the companies they deal in, and invariably go to stock lenders to help fill orders. That’s where problems come in, at least for little-traded stocks hard to get hold of. One senior source gets into the market mechanics to explain the difficulties. He says: “You want to buy £3000 worth of Little Known Mining Stock. I am a market maker. I am obliged to quote you a price, and there are only two market makers. I sell you £3000 worth of LKMS, but I don’t own them. I don’t want to chase the price up buying them back from the only other market maker. I can’t borrow them: no lender would have them in their account to lend as company is too small. I can’t really buy from a holder — maybe they’re not easy to find — it could be a low free-float or overseas holders for example, so I wait to complete the trade.”
He adds: “CSDR wants to impose daily fines and buy-in charges to ensure prompt settlement and exchange of cash for shares. It all makes sense, but at the moment, there is no exemption for market makers.
“Consider your £3000 trade in LKMS. If I can’t settle, I could rack up daily fines and then suffer a buy-in charge of 10% above the price I sold the stock at. That might total say, £300, that’s 10% of the consideration. Even if it were £100, that’s still 3.33% of the consideration.”
He adds: “It’s a huge disincentive to be a market maker.”
Andy Hill, senior director at the International Capital Markets Association, does not oppose settlement discipline but has major concerns with mandatory buy-ins as the cost “will be borne most directly by investors”.
“Spreads will widen significantly, even for the most liquid sovereign bonds, while in the case of less-liquid corporate bonds market makers will retreat from showing offers in securities that they do not already hold. Ultimately, this expected loss of liquidity is likely to feed through to the cost of issuance, impacting sovereigns as well as corporates. With smaller, lessfrequent issuers, it may be a barrier to accessing capital markets altogether.”
INDUSTRY observers note the irony of the European Securities and Markets Association’s drive to improve settlement with a penalties regime which could hike costs and squeeze more companies out of capital markets, all at a time when the MiFID II rules have devastated analyst coverage of smaller stocks by forcing brokers to charge. As one despairing market maker said: “We’re shooting ourselves in the foot at exactly the wrong time.”