The presence of middlemen in the markets keeps the market liquid, or flowing; so investors can buy and sell easily and with little transactional cost. The MiFID II text currently under discussion contains several clauses that will have a profound effect on the practice of market making within Europe, determining the future liquidity of the European financial markets.

MiFID II is giving market makers mixed messages. On the one hand, European lawmakers have confirmed their crucial role in the markets by imposing obligations to stay in the market all the time.

This is particularly important as Europe wants to stimulate growth by increasing the number of companies raising capital on European securities exchanges (through initial public offerings or IPOs). Meanwhile, banks across the board are retreating from market making and deleveraging (getting rid of debt). Without independent market makers, companies’ ability to raise capital would be constrained, prices more volatile, and the markets all around more expensive to trade.

On the other hand, the same lawmakers seem to be suffocating market makers with bureaucracy. Current proposals place so many restrictions on market makers, that if they come to pass, we will see many of these firms simply cease performing that role altogether. There is a danger that schemes now in circulation will mean that in five years, European market liquidity will be at an all-time low.

A crucial part of the market maker role is the ability to monitor and keep prices consistent across trading venues. In doing this job, market makers face two types of problem:

• ·  an inventory-management problem – how much stock to hold and at what price to buy and sell. Market makers earn money from these trades in the form of a bid-ask spread - reward for taking the risk that their inventory loses value
• ·  an information-management problem. By providing both bid and ask quotes, a market maker opens himself up to the risk of losing out to informed traders who know more about asset values. The bid-ask spread is designed to protect against this risk, and market makers can widen the bid-ask spread as a buffer.

Nevertheless, in recent history, bid-ask spreads have only decreased, due mainly to improved technology. This has increased the speed of trading, and enabled the development of automated, highly responsive and effective risk management systems that allow market makers to process information and update quotes more quickly, limiting their exposure when prices become out of date.

This requires market makers to invest huge amounts in technology and infrastructure, and even then they do not make money on every trade, continuing to face real financial risk.

As a result, trading venues who want to encourage market makers to provide tighter quotes choose to reward bona fide market makers with appropriate incentives, and to allow the widening of spreads or temporary market exits in times of distress. This enables market makers to pause, assess and engage in prudent risk management.

These factors, combined, make it possible for market makers today to contribute to the most efficient markets in history, while managing risks effectively and preserving market stability.

Draft rules may undermine this. Market makers may be obligated to stay in the market on a near continuous basis, without the flexibility to stop quoting when prudent risk management would dictate pausing to assess.

In addition, incentives – which compensate them for bearing risk involved in providing liquidity – may be limited. Minimising or removing incentives in the form of rebates or other compensation already makes it doubtful whether market making will continue to be profitable. But proposals to implement systems to further penalise firms who may not meet stringent quoting obligations mean that it is likely to become loss-making.

It’s worth remembering that modern markets have greater transparency of order flow information than ever; the traditional advantage dealers had over the investing market no longer applies. As this advantage is reduced, so should the regulatory requirements on those who expose themselves through quoting prices to both buyer and seller.

In times where economic recovery is a must, policy should free up firms serving the critical role of market making to be able to continue to provide this social benefit, by recognising their need to manage their risks and be compensated commensurate with the hazards they bear and services they provide. We believe regulation should be a framework for markets participants to make sound choices and operate responsibly and efficiently, not the replacement for free choice.

In the final analysis, if rules make it impossible for market makers to carry out their job safely or economically, then they may become obsolete – making markets less liquid, and therefore undermining their fundamental societal role of distributing capital from those who have it to invest to those who need it to generate economic growth.

Content belongs to EurActiv.com For the original please visit: http://www.euractiv.com/sections/euro-finance/mifid-ii-giving-market-makers-mixed-messages-303467