The 2008 financial crisis amplified regulatory focus for the entire industry. It was also a catalyst for a host of structural market changes across the globe that were tailored to prevent another crisis and protect investor interests. While regulators have focused on these structural reforms, market participants continue to innovate and as a result the use of technology and automation in trading has reached new levels. Increased market complexity and the application of technology for trading opens the door for greater use of quantitative metrics for monitoring, surveillance and enforcement of trading practices.

The Time is Now– Best Execution and MiFID II

The 2008 financial crisis amplified regulatory focus for the entire industry. It was also a catalyst for a host of structural market changes across the globe that were tailored to prevent another crisis and protect investor interests. While regulators have focused on these structural reforms, market participants continue to innovate and as a result the use of technology and automation in trading has reached new levels. Increased market complexity and the application of technology for trading opens the door for greater use of quantitative metrics for monitoring, surveillance and enforcement of trading practices.

Markets in Financial Instrument Directive II (MiFID II) remodels best-execution rules and puts greater emphasis on monitoring, transparency of trade information and establishing robust processes that prove that best execution was achieved. The new rules will require market participants to incorporate technology to meet the regulatory obligation – the change effort needed to do this should not be underestimated.

The underlying policy behind these new rules with MiFID II has not changed significantly from MiFID. The factors used to evaluate best execution are the same and price remains the dominant factor. However, where under MiFID it was sufficient for an investment firm to have an execution policy in place listing the venue (s) they ‘may’ trade with, MiFID II requires that the execution policy be ‘clear and sufficiently detailed’ and drafted in a way that can be easily understood by clients.

There is increased onus for firms to take all ‘sufficient’ steps, rather than all ‘reasonable’ steps, to obtain the best possible result for the client. The enhanced rule also focuses on transparency and obligates trading venues to publish data related to execution quality annually. Investment firms will have to publish, on an annual basis, their top five execution venues, for the previous year, along with specific data related to the quality of execution.

Although on the surface there does not appear to be too many changes to the policy, the regulatory expectations behind these rules and the implementation effort required to comply cannot be underestimated.  The UK FCA recent Thematic Review revealed that most firms are currently not doing enough to deliver best execution through adequate management focus, front office business practices and supported controls. They further stated their commitment to policing these issues more proactively in the future.

MiFID II will place new demands on legacy infrastructure as firms process more data to monitor and defend their execution strategy, in particular their choice of venue. Since greater emphasis is being placed on execution quality, investment firms will need to step back and evaluate the new rules against their current business work flow. The new rules require investment firms to have the ability to demonstrate consistent best execution on ‘demand’ to clients and regulators. This implies that a policy must be in place and there must be a process or mechanism to monitor executions in a timely manner.

One shortcoming of MiFID was its failure to provide a market mechanism to bring together pricing data – like the U.S. consolidated tape – to ensure transparency and best execution when trading on multiple platforms. MiFID II tries to address some of the limitations of MiFID and allows for a consolidated tape provider (CTP) and the ability to mandate a utility model if an industry solution is not achievable. Theoretically a CTP would provide an independent cost-effective mechanism for clients to judge execution quality and the merits of the trading system being offered to them. However, finding the right price point that will satisfy both the end customer and the market data providers will be challenging and may take some time.

In lieu of a consolidated tape, many investment advisors use Transaction Cost Analysis (TCA) to determine whether trades were arranged at favourable prices. TCA products for equities have been around for some time however, MiFID II expands the product scope to include debt instruments, interest rates, credit, currency, equity, securitized and commodities derivatives (listed futures and options and swaps, forwards and other derivatives), CFDs and emission allowances.  These products have historically traded over-the-counter (OTC) and transaction cost analysis solutions have only recently being embedded into the workflow of order management systems. This makes the task ahead in meeting the best execution obligations under MiFID II extensive, costly and time consuming for investment firms trading these products.

Moving forward from what they policy says to what actually needs to be done to tackle implementation efficiently, investment firms should first take a critical look at their workflow (how they trade, who they trade with etc.) in light of the new rules and assess the adequacy of their systems and controls. Some of the new obligations could challenge legacy infrastructures and current processes and methodologies.  If the current systems prove to be inadequate or require upgrading, an evaluation of alternative vendor solutions will need to take place and the chosen solution will need to be implemented and integrated into workflow.

Many firms will need to source and maintain more market data to meet their best execution obligation; not only to defend their choice of venue but also to effectively select brokers. Investment firms will have to capture extended data points to fulfil their obligation to publish venue information and prove charges and fees are in the best interest of clients. The data requirements to support best execution should be viewed alongside other data obligations under MiFID II, for example for meeting the trade reporting obligation, and all data requirements should be integrated into a holistic data strategy.

MiFID II also requires enhanced monitoring tools as there is greater onus on firms to prove best execution. Historically best execution tools for fixed income have been limited – mainly due to the liquidity profile of the fixed income market and the number of instruments. As more product is being traded on venues, TCA products are becoming more prevalent. However, there will never be a one-size fits all solution due to the nature of the fixed income market and implementing an overall sound methodology will be key. Compliance and risk departments will need to enhance monitoring and surveillance tools to a sufficiently granular level to demonstrate that a consistent best execution methodology is being followed.

There will be a good deal of paperwork ahead. Client facing documents such as the terms and conditions will need to be drafted to clarify and explain a firm’s approach to best execution.  Investment firms are also required to publish a summary of its analysis and conclusions drawn from its monitoring of best execution quality obtained during the preceding year.

As regulators increase their attention on compliance of these rules, so will Boards. Firms must ensure they have a robust governance framework with adequate processes in place to provide regular reports on compliance to the Board.

Although the best execution rules under MiFID II have been adapted to address the increasing complexity of automated markets, the fundamental principle to ensure beneficial outcomes for clients remains unchanged. The new rules create data challenges that should be addressed early to keep costs down and minimize the change efforts. Regardless of where the market ends up on the issue of market data costs, the best execution obligation persists and market participants need to take the necessary steps to ensure compliance.

This information is intended for information purposes and does not constitute legal advice.