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UK watchdog to keep close eye on corporate bond market's liquidity

* Regulator says not yet decided if intervention needed

* Industry warns about impact of EU rules on liquidity (Adds industry letter to regulators)

By Huw Jones

LONDON, March 10 (Reuters) - Britain's financial regulator said on Tuesday that a low liquidity in corporate bond markets, which could create volatility in times of stress, needed careful monitoring.

But trying to improve liquidity by relaxing strict new capital requirements imposed on banks since the financial crisis was not an option, the regulator said.

Investors have poured money into corporate bonds since the crisis to boost returns but this has prompted concerns that some markets do not have enough liquidity to cope with a rush for the exits when interest rates start to rise.

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Commentators have warned this could result in fire-sale prices and extreme volatility in markets.

The liquidity issue has also arisen at a time when the European Union is looking to build a "capital markets union" to plug gaps in corporate funding left by banks that have reined in lending.

Edwin Schooling-Latter, head of market infrastructure at the Financial Conduct Authority (FCA), told a FIX Trading conference that the state of the secondary corporate bond market, where bonds are traded after they have been sold to investors, was on the regulatory agenda.

"There is enough evidence that low liquidity relative to previous years does warrant careful regulatory monitoring of market developments and careful consideration of what could be done to improve levels of liquidity," he said.

"We don't see a single silver bullet."

Morgan Stanley (Xetra: 885836 - news) has said that the average number of dealers per trade in the bond market has dropped to 3.2 in January this year from nearly 9 in 2009.

This reflects the new capital requirements banks have to meet which banks say has made bond trading more costly.

Schooling-Latter said that before regulators themselves intervened they must ask if there is a market failure. "We would certainly be interested in views from market participants if that is the case."

"The focus of policy makers' attention is not on reversing new prudential requirements," Schooling-Latter said.

Enhancing price transparency was one option under consideration as a way to make investors more willing to trade, he said.

Other ideas included improving trading platforms, more retail participation, greater standardisation of bond issuance and making the allocation of initial issuance more transparent, Schooling-Latter said.

Bond issuers also have a key role to play such as encouraging platform trading in their bonds at the outset to reach a wider range of investors, he added.

He said it was timely to review primary market regulation such as easing EU rules on prospectuses for issuers, a step Brussels is already looking at to boost market-based financing.

Separately, industry bodies like the French and Dutch asset management associations, Britain's The Investment Association, as well as investment groups such as BlackRock (NYSE: BLK - news) and Aviva (Other OTC: AIVAF - news) , have proposed changes to planned EU bond market transparency rules known as MiFID II.

They said it was "highly challenging" to apply the MiFID II rules to less widely traded bonds without crimping market efficiency.

"To deliver sustainable economic growth in the EU, the starting point for MiFID II ... needs to be the interests of Europe's saving and investing citizens and companies," they said in a letter, seen by Reuters, to the EU securities watchdog ESMA. (Writing by Kirstin Ridley; Editing by Jane Merriman and Greg Mahlich)