STEPPING UP TO THE PLATE.
Dr Anthony Kirby looks at how the game is changing for order driven and RFQ.
The topic of best execution is interesting because it represents the bridge between innovation in the markets and the regulatory conduct of business (CoB) rules which are designed to protect the investor. MiFID I, which took effect in November 2007, introduced a multi-factor based approach with regard to best execution, in comparison with previous definitions which were in common use in other jurisdictions such as the US, based merely on best price.
Since then, the financial markets have changed substantially as a result of the financial crisis, the prudential and conduct regulatory responses, and the technological innovations. The number of trading venues has increased by 44% and the number of registered MTFs has jumped by 78%, while the number of systematic internalisers (SI) has stood steady at around a dozen firms. The flow of equities classified as high frequency traded (HFT) increased more than six-fold, as did the amount of equities flow placed in dark pools. Both the market impact to the investor and the number of algorithms have both near-tripled in the meantime.
MiFID I certainly delivered more choice to the securities industry in Europe, but clearly at the expense of fragmenting order flow. Most buyside heads of trading understand the current challenge when dealing in size has been the market impact associated with signalling risk when trying to locate quality liquidity. The collapse of block trading (the result of narrowing capital commitment given demands for quality capital elsewhere), the abuse of dark pools, the proliferation of HFT market-makers (powered by lower-latency architectures), and the re-consolidation of market venues have all worked to confuse attempts for firms to evidence best execution procedures to their clients, particularly in non-equities.
MiFID I article 21 obliged investment firms to take all reasonable steps to execute orders on terms most favourable to the client, and to obtain the most favourable 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, whether trading occurred on- or off-exchange. Many firms since 2010 have adopted a ‘MiFID I.5’ approach revising their best execution policies with regard to the execution arrangements surrounding types of ETFs such as synthetic ETFs, and particularly when evidencing best execution with regard to an evolving broader market for non-equities.
It is not surprising that regulators were keen to press for closer scrutiny of best execution with qualification for certain asset classes given the large behavioural shifts needed for voice trading, and the trade-offs between transparency and liquidity under the new MiFID II Level I text issued in April this year. The form of the legal text is tougher. Article 27(1) states, for example, that ‘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.
A big ask
This is a challenging ask in a market fragmented as described above, and it’s a considerable game-changer for quote-driven (RFQ) markets such as fixed income, currencies and commodities, even if some heads of trading have still to realise that. These markets feature extensive voice-trading, indications rather than trade prints, and they do not benefit from the use of transaction cost analysis (TCA) tools. The best execution requirements, innocuous in themselves, will be introduced to the bond and derivative markets (comprising asset classes as diverse as government, corporate, high-yield and emerging market debt, asset-backed securities, and OTC-traded derivatives – in both liquid and illiquid form, depending on the instrument, maturity and market conditions).
The reference to ‘all sufficient steps’ represents a step-up from the original MiFID I text and will formalise the factor-based approach (‘price’, ‘costs’, ‘speed’, ‘likelihood of execution’) – see Figure 1. When coupled with applying the European Commission’s 4-part ‘legitimate reliance’ tests* when firms are ‘executing orders on behalf of clients’ (as opposed to ‘arranging deals in investments’) or when applying the supplying requirement to evidence costs (‘total consideration’), it is clear that the MiFID II measures will be significantly more burdensome for market intermediaries.
Requirements for greater disclosure by dealers might also lead to a tightening in the number of firms prepared to commit their capital to hold inventory or make prices. Firms have also expressed fears of complications arising from the interplay of regional and local (including thematic) measures (e.g. the FCA’s Thematic Review in the UK, new HFT laws in Germany and France, and caps on the order to trade ratios introduced in Germany). The liquidity characteristics of the instruments (under ‘normal’/’stressed’ market conditions) are an additional consideration. However, many small- or mid-sized buy- and sell-side firms are not where they need to be. On the buyside, many haven’t linked their PMS/ OMS/TCA systems together, and therefore place undue reliance on their brokers to effect best execution.
The MiFID II’s LI text (accompanied by the ESMA/2014/548&9 papers) describe “WHAT” needs to be done to tighten up best execution, while the FCA’s TR14-13 describes ‘good’ and ‘poor’ practices to illustrate “HOW” this might be achieved. For example, the true focus on increased disclosure of costs under MiFID II for investment firms acting on behalf of retail-classified clients seems relatively open-ended. If execution is performed for retail clients, due consideration should take account of explicit and implicit costs e.g. expenses (execution venue fees, regulatory levies, taxes, clearing/settlement fees, third-party fees) and commissions, per each eligible execution venue featured in the firm’s best execution policy.
Some politicians who have familiarity with the FMCG (fast moving consumer goods) sector have expectations that the financial industry equally inform retail clients in the manner of price comparison websites, carrying the presumption that more information is better. Given that ‘best execution’ falls under the scope of directive (and not regulation), this author would argue that the industry would benefit from a consistent codification of expectations in each Member State. Moving forward, it is clear that firms will need to migrate beyond today’s simple workflows, and devise a ‘Big Data’ approach to data mining.
If this is the direction of travel, then the areas for improvement will include:
- Increasing both precision and availability of data relating to IOIs, RFQ/S/M,
- Increasing the granularity of data drawn from the ‘broader markets’ – to replace the screenscrapes that are in frequent use today
- Increasing the level of forensics – unstructured data such as voice/e-mail/text runs creates problems of evidencing.
This is not to say that there won’t be significant benefits with improving the clarity under the MiFID II best execution regime. Far from it. The immediate benefit will be greater transparency for the buyside and better accountability to end investors, which would ordinarily lead to greater confidence when exercising trading decisions and thence a greater trading velocity. Improved transparency could also foster better accountability and better confidence, leading onto better liquidity.
Future innovations may well arise out of MiFID II spanning fixed income/FX TCA, RFQ streaming (equivalent of SOR); fixed income algorithms and ‘all-to-all’ liquidity approaches that we have seen in the fixed income markets of late. Firms may decide to innovate by producing tools themselves, monetise through collaborations via ventures, or rely on market-led/FMI-led approaches. MiFID I showed form in all of these areas – who is to say that MiFID II cannot create opportunities for venue and vendor providers alike when creating more flow-business opportunities?
Any views expressed are the author’s own and should be used for information and reference purposes only and not intended to provide legal, tax, accounting, investment, financial or other professional advice on any matter.
* The Commission Opinion set out a list of the four-fold test to help determine whether a client is legitimately relying on the firm:
• Which party initiates the transaction
• Questions of market practice and the existence of a convention to ‘shop around’
• The relative levels of price transparency within a market
• The information provided by the firm and any agreement reached
© BestExecution 2015