OTC best execution and MiFID II

Whilst everyone talks quickly about the future impact of MiFID II, there is a more immediate impact for UK-based firms given the FCA focus on remediation, following their thematic review
December 4, 2017 - Editor
Category: MiFID II

Whilst everyone talks quickly about the future impact of MiFID II, there is a more immediate impact for UK-based firms given the FCA focus on remediation, following their thematic review of asset managers. The FCA has made it increasingly clear in a series of industry engagements, from the thematic review in 2014, to the Press Release in March this year, that firms are not taking sufficient action to ensure their clients receive best execution.There is a particular focus on the OTC Fixed Income, Currency and Commodity markets. MiFID itself then adds to the complexity and the devil, as always, is in the detail.

Whilst everyone talks quickly about the future impact of MiFID II, there is a more immediate impact for UK-based firms given the FCA focus on remediation, following their thematic review of asset managers. The FCA has made it increasingly clear in a series of industry engagements, from the thematic review in 2014, to the Press Release in March this year, that firms are not taking sufficient action to ensure their clients receive best execution.There is a particular focus on the OTC Fixed Income, Currency and Commodity markets. MiFID itself then adds to the complexity and the devil, as always, is in the detail.

Almost every firm will already have an execution policy that encompasses some sort of best execution. However, many are not available to the public and most will not detail which execution venues are on the list when choosing where to execute. Most will not articulate the details of which elements are under consideration when choosing which price to hit, or how they are prioritised in order to achieve a consistent best execution.

The monitoring of execution and the feedback loop that optimises execution over time to ensure compliance, is rarely well documented or implemented as efficiently as a firm might wish; especially when reconsidering things through the lens of MiFID requirements.

The same template is required to be used across all trading, although the details of implementation will clearly differ across different sub-asset classes and client types. The challenge in liquid FX trading may focus on handling  ‘big data’ and market impact, whilst trading in illiquid corporate bonds may focus on understanding what a ‘fair underlying comparative price’ may be.


MiFID II Best Execution

The MiFID II best execution regime formalises what many would consider to be best industry practice. The challenge however is two-fold: firstly, an investment firm must translate the rules that are used in an established exchange environment of equity trading to encompass the world of OTC trading with a range from highly liquid but multiple venue FX trading with millions of prices a minute, to completely illiquid corporate bond trading where a bond may not have traded for months.

The second issue is that this challenge is not addressed in isolation. If investment firms were able to approach best execution as a standalone project, it would perhaps be more straightforward. However, firms do not have that luxury. The industry is currently faced with a broad range of change and implementation projects that cover all areas of the business, from trading procedures and trade reporting to research unbundling and product governance – with the resulting budget prioritisation challenges.


MiFID II Best Execution – the four elements 

Best execution can be looked at through the lens of four inter-locking elements; Policy, Execution, Monitoring and Reporting. Each involves a process oriented approach which should be under regular review for optimisation and to ensure continued compliance. 

The MiFID text states under article 27 of the EU Directive 2014/65/EU:

“Member States shall require that investment firms take all sufficient steps to obtain, when executing orders, the best possible result for their clients taking into account price, costs, speed, likelihood of execution and settlement, size, nature or any other consideration relevant to the execution of the order. Nevertheless, where there is a specific instruction from the client the investment firm shall execute the order following the specific instruction.”

The Delegated Acts go into some more detail, however they do not define exactly how to measure the underlying market price for comparison, nor do they define how the various elements of trade process such as likelihood to trade and price should phase together in the execution decision making process. Given the phrase has been upgraded from MiFID I “reasonable” to MiFID II “sufficient”, there is a new onus on firms to take this implementation seriously – as what may have seemed “sufficient” prior to a problem surfacing, may subsequently appear clearly insufficient when an issue arises with a client trade, sometime after execution. With the Senior Managers and Certification Regime about to hit the investment management community, the personally direct consequences of not looking after clients sufficiently will take on a new seriousness.

Building an execution policy will be highly dependent on the firm’s ability to execute and the sub-asset class in question. A minimum number of venues is not laid down by the regime and this again will depend on the above. It is possible to engage a single venue, and to include the firm’s own proprietary trading desk, providing that this can be justified in the context of best execution. The required results from the execution policy are not that every single trade has to conform to the policy, but rather that any given client will enjoy best execution on an overall and consistent basis.

Execution policies are not a new concept of course, however the degree of public disclosure and required understanding by the investors is at an entirely new level. The policy must contain enough detail that the investors will understand how their orders are to be handled, including how costs will be taken into account and which execution venues may be selected for the trading process.

The execution itself must follow the policy and the monitoring of this process is crucial so as to ensure that there is a positive feedback loop that flexes the elements in the policy to optimise the execution through time. Inevitably the levers that will be flexed in the execution process will vary significantly by factors such as client, asset and venue. Clearing ability and its explicit costs along with custodial costs may be core considerations in trading a corporate bond, whilst implicit cost of market impact and likelihood to trade given some price makers’ last look implementation may be the major factors in FX trading.

Monitoring the execution process and building a quantitative feedback loop that adjusts the execution elements is crucial. A firm will be expected to demonstrate how they have incorporated the various outputs from the execution experience to optimise the ongoing execution process.

Finally, the reporting required by investment firms to cover the best execution requirements will require a highly process-oriented approach so as to ensure compliance. Not only must each potential execution venue be monitored, with elements of execution quality recorded throughout the year, but firms must also publish the results of their execution on an annual basis, with details of that selection process and quality of execution for the top 5 venues by asset class. The implications of this openness around execution policy outcomes and venue execution quality, are yet to become clear – however this must surely drive behaviour over time.

MiFID II Best Execution – measuring execution criteria

Conversation around monitoring best execution usually focuses very quickly on the measurement of the various criteria and what this might mean in practice.

Best execution is clearly far more than finding the highest bid or lowest ask. A firm may have access to any number of execution venues and could see, for instance, 9 simultaneous bids at the same price. Which one to choose? This is where a strong understanding of the post-trade analysis is key. A large order may well be split into a number of smaller transactions and understanding which venues exacerbate the toxicity (market impact or footprint analysis) of a given transaction should be a significant driver of venue choice.

Last Look is a topic of some focus in both the FX markets and the press currently, and can drastically affect the profitability of execution over time. Whilst some might sometimes view this as an esoteric area of the trade process, Last Look is a topic that should be taken into account in any modern cost analysis, to drive part of the best execution process. As mentioned above, finding the highest bid may at first seem to be a sensible approach, however if that bid turns out not to be as “executable” as it at first appeared due to Last Look rejection, then the process needs to be re-examined.

Last Look takes place when the price maker’s price is cleanly ‘hit’ by the client but the price maker decides to refuse that execution. This is not looking at ‘in flight miss’, but rather the “post-execution” refusal of a trade. This process has been common-place in almost all banks’ execution policies over the last decade or more and whilst the use of Last Look is altering in the details of implementation, it remains at the heart of whether a price is indicative, firm or somewhere in the middle. 

Whether executing a formal iceberg set of transactions, or simply cutting up a large order into bite-size pieces, an investment firm will need to ensure as little information is leaked to the wider OTC market as possible. The days of simply asking your regular 5 banks and hitting one of those prices, are long past!

Best Execution and the FCA

On top of the MiFID II pressures, those asset managers operating in the UK have a more immediate concern when considering how they currently manage best execution. The FCA undertook a thematic review of the financial market industry in 2014, to realise a clear view of how best execution was being managed by investment firms. The review was positioned from the perspective that the FCA was concerned that firms were not doing enough to ensure that their clients were indeed receiving best execution.

On the 3rd March this year, the FCA issued a Press Release entitled ‘Investment managers still failing to ensure effective oversight of best execution’, which was quite specific on its focus, expectations, intentions and timing.

The FCA stated “We publish thematic reviews to initiate improvements across the whole sector”. In the following section the text commences with “We were concerned to find that most firms had failed to take on board the findings of our thematic review. The pace of change in improving client outcomes in best execution was slow, with few firms having a cohesive strategy for improving client outcomes. Many firms had not conducted a robust gap analysis since 2014 and therefore much of the poor practice we outlined in our thematic review had not been addressed.”

In their sector review that was released in April, this was further underlined when they expressed a concern that “Some investment managers may pay too much for services on behalf of investors due to… …failure to consistently monitor, assess and deliver on ‘best execution’”.


Industry challenge

The Press Release makes it clear that “all the firms we visited had management information that allowed them to accurately view equity execution costs, however use of these data was inconsistent. Some firms could not evidence any improvement to their execution process based on these data and the review of it was largely a ‘tick box’ exercise”.

The Release continues: “Best execution monitoring in fixed income was less sophisticated than in equity trading. We recognise there are particular challenges for this asset class, but some firms have been more proactive in how they meet their obligations than others. This highlights that meaningful steps can be undertaken to ensure best execution even in less transparent markets”.

In fulfilling its stated intention to ‘revisit best execution in 2017’, the FCA is expected to conduct a survey of a large number of firms, followed by visits to a selected group of those firms, especially those that are unable to provide robust responses to its survey. Firms should be in no doubt that if they are identified as failing to meet the FCA’s stated expectations, they will be taken formally to task, possibly with enforcement action.

The FCA is particularly insisting that firms can show that they have carried out a gap analysis of their procedures against the position set out in TR14/13. In any review that the FCA undertakes at firms, that gap analysis will be the first document that they seek to inspect. Absence of, or inadequacy in, the gap analysis will certainly lead to further investigation and likely action.


What happens next?

An initial gap analysis review is essential to benchmark the firm’s current policy for best execution against the results of the 2014 thematic review, its recommendations and the MiFID definitions. Every firm needs to be clear as to how their policy compares to the ideal scenario and in the case of any gaps, to have a clear picture as to how they plan to remediate. Given the approaching implementation of MiFID II, in which Best Execution is a major element of Investor Protection, this assumes a clear significance today.

Following a review of the Best Execution Policy documents, a firm may well wish to test the reality of the monitoring outputs against the actual execution, so as to be in a position to inform the FCA of the outcome with confidence.



  • MiFID II go-live date of 3rd January 2018 is fast approaching and firms must be compliant by then
  • FCA has been clear and specific in its repeated demands for better delivery of best execution
  • FCA’s Press Release of 3.3.17 stressed the need for a gap analysis of firms’ procedures against its thematic review report (TR14/13)
  • FCA will take action against those that have failed to meet expected standards

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