THE TCA CHALLENGE.
Chris Hall assesses the changing face of TCA to help buyside firms achieve best execution.
In the ten years since the original MiFID codified the best execution obligations of European Union-based investment firms, the expectations of regulators and investors have steadily risen.
From January 2018, MiFID II and its associated regulation will raise the bar again – not least through its requirement for firms to take all sufficient steps rather than “all reasonable steps to obtain, when executing orders on behalf of clients, the best possible result”, as laid out in the original directive.
“Many of the best execution policies adopted by the buyside under MiFID remain too generic and are seen by some regulators as failing to ensure effective oversight, therefore missing the opportunity to improve client outcomes,” says Rebecca Healey, head of market structure and strategy at Liquidnet .
However, buyside monitoring of execution quality has not stood still, even if some best execution policies have gathered dust. Multiple regulatory initiatives, market structure developments and disruptive technologies – not to mention the occasional scandal – have heaped attention on how investment ideas are implemented by buyside trading desks and how orders are executed by their sellside execution brokers.
“The publication of Michael Lewis’ ‘Flash Boys’, for example, forced many on the buyside to understand market structure more deeply than previously,” says Mark Northwood, principal at Bips Global Limited, formerly global head of equity trading at Fidelity International. “Clients asked a lot more questions about the execution services asset managers were getting from their brokers.”
Meanwhile, regulators also made their feelings known. The Financial Conduct Authority issued a warning shot with its 2014 thematic review on best execution and payment for order flow, followed by a buyside-focused market study published last November. In March, the UK watchdog said it would revisit best execution throughout 2017, warning: “If we find that firms are still not fulfilling their best execution obligations, we will consider appropriate action.”
While the European Securities and Markets Authority is applying the finishing touches to MiFID II, its best execution rules are broadly clear. As well as the change to “all sufficient steps”, the obligation is extended to OTC instruments and there is a greater emphasis on fairness of price. Further, MiFID II mandates use of data from brokers and venues, outlines the clarity and level of detail required in best execution policies and demands procedures to identify and remedy “deficiencies”.
With so much attention on equities best execution since 2007, it’s inevitable that preparations for MiFID II will vary across asset classes. As Paul Collins, head of EMEA trading at Franklin Templeton Investments, notes, “For us, MiFID II represents an evolution in equities, but is more akin to a revolution in fixed income. A number of the projects we’ve implemented in recent years will help us meet our best execution obligations under MiFID II for equities, but we – and the market as a whole – are still in the request for information stage in terms of how we strengthen the monitoring and measurement of fixed-income trading performance: the products are not quite there yet.”
The TCA evolution
Transaction cost analysis (TCA) has had to evolve as scrutiny of outcomes has intensified and market structure has become more complex, but to support best execution it is increasingly used alongside a wider range of inputs within a framework geared toward identifying and addressing the causes of under-performance.
For equities, Franklin Templeton conducts its own ex-post TCA in-house using data collected from brokers and trading venues, but also benchmarks performance via a peer analysis service from a third-party provider. The firm uses services from OTAS Technologies to source real-time inputs that could influence trading strategy selection during the order execution process, which ensures responsiveness to market conditions and militates against outliers. Franklin Templeton is also in the process of implementing a new multi-asset class execution management system (EMS).
In an era of self-directed trading, buyside desks used TCA to demonstrate cost-effective implementation of investment ideas to end-investors. However, post-MiFID fragmentation of liquidity, diversification of trading venue models, and the development of smart order routers posed new questions. TCA can tell the trader how an order performed against pre-trade expectations, but did that router miss out on the best price by accident or design?
“You can only achieve best execution consistently if you have processes in place to ensure you’re choosing the right venue, algorithm, broker etc. That means having access to all the relevant data in a timely manner which will support a robust and multi-faceted approach to measurement,” says Collins.
TCA must lead to meaningful improvements in the trading process, says Northwood, rather than serving just as a monitoring exercise. “To improve, you must experiment. And to experiment, you must have a framework that measures the impact of any changes or tweaks on trading outcomes. You need a robust analytical approach to be able to draw conclusions,” he explains. “But it’s also important to step back and look at the big picture. The value you can add by executing an order on one venue versus another is marginal compared with identifying the most suitable trading strategy for implementing a particular investment idea.”
Collins asserts the central importance of technology in helping the buyside to improve oversight of orders, for example by alerting the trader if an order is straying outside the ‘bell curve’ of acceptable or anticipated limits and providing decision-support information. As buyside firms rely less on their brokers’ sales traders and more on their own selection and monitoring of trading strategies, Collins emphasises the ability of buyside firms to blend quantitative and qualitative analysis in pursuit of best execution. “We feel it is important to have a vendor-neutral trading infrastructure so that we can combine best-of-breed technologies,” he says.
It’s not just larger firms such as Franklin Templeton that have been exploiting greater access to more granular and more immediate data to improve pre- and post-trade analytics. “The buyside has been getting to grips with issues such as onward routing of orders, helped by the ability to track FIX tags 29, 30 and 851. They’re better able to challenge and query their brokers’ decisions and execution performance, especially in liquid stocks,” says Healey, who predicts MiFID II will shed further light. “With so much more data becoming publicly available under RTS 27 and 28, the regulators’ intention is that it will become easier for the buyside to compare the information provided by current execution partners against other brokers and venues to ensure they’re achieving best execution.”
Anish Puaar, market structure analyst, Europe at Rosenblatt Securities, suggests the buyside will have to be selective. “The value to the end-investor of some of the data that exchanges and venues must make available under MiFID II is questionable,” he says. ”The time delay is also an issue as some data could be as much as six months old by the time it is released.”
Shining a brighter light into fixed income
Although the new data requirements vary across venue types, it is expected that MiFID II will help boost price transparency in the OTC markets in the longer term. Nevertheless, differences between equities and fixed-income markets – notably in number of instruments and volume – warrant a different approach to TCA and best execution monitoring.
Platform operator Tradeweb, which provides electronic trading across a wide range of fixed income and derivatives markets, is leveraging proprietary market data that supports its price discovery capabilities to offer a new kind of TCA product. Based on price feeds from 40-plus liquidity providers, Tradeweb supplies live bid-offer composite spreads that can be used by buyside fixed-income traders to compare their own executions to prevailing prices in the market in cash terms, but also analyses orders as a proportion of the bid-offer spread. The firm also offers peer comparison on a quarterly basis.
“Our TCA service started off as a tool to help traders on the desk identify areas for improvement, but with MiFID II’s best execution requirements upcoming, it is increasingly being used by compliance teams, for example to help explain outliers as part of an ex-post process,” says Charlie Campbell-Johnston, head of business operations, International at Tradeweb.
Accepting that there are fewer data points available in the fixed-income market for comparison of execution outcomes versus for equities or FX, Alfred Eskandar, CEO of trading technology vendor Portware, argues that the process of using post-trade data to inform pre-trade decisions is transferable across asset classes. Moreover, he believes it can be more highly automated, with a broader range of data sources feeding into the decision-support process as the use of open APIs increases.
“Ultimately, the aim should be to support the buyside in the development of intelligent workflows,” says Eskandar. Portware’s latest EMS serves as a virtual trading assistant by recommending trading strategies for incoming orders, providing anticipated impact and duration assessments, based on up to 150 pre-trade inputs. With technology guiding and monitoring an ever higher percentage of orders, buyside desks will increasingly trade by exception.
“Some firms are already automating 65-70% of equity trades, which allows them to adopt new skills and contribute to the investment workflow in new ways. For buyside traders, differentiation will come through how they handle unique, complex and difficult trades,” says Eskandar.