TRANSACTION COST ANALYSIS IN A MIFID II WORLD.

Anna Pajor – Managing Consultant and Head of GreySpark’s Capital Markets Intelligence practice.

Imminent transparency

The EU’s Markets in Financial Instruments Regulation (MiFIR) and the second iteration of the Markets in Financial Instruments Directive (MiFID II) are changing the region’s capital markets landscape by altering the approaches buyside firms and investment banks take in making trading processes more transparent to their respective groups of clients. This article comments on the main challenges and changes within the range of transaction cost analysis (TCA) services expected by and offered by asset managers, institutional investors and banks, as well as the best execution reporting mandates each type of company will need to comply with in the near-future.

The overarching principles of transparency inherent in the EU’s new rules are affecting all aspects of the trade lifecycle. Specifically:

• pre-trade and post-trade through the publication of quotes and transaction reporting;
• all asset classes, through rules for equities, equity-like products, bonds, OTC and listed derivatives and structured products;
• all types of trading organisations – regulated markets, multilateral trading facilities, newly-created organised trading facilities and systematic internalisers;
• the creation of granular information related to the decision-maker behind an investment decision or a detailed breakdown of all costs related to a trade; and
• the annual reporting of execution quality at the leading trading venues.

The main game-changers for the EU’s revised trade transparency rules are the creation of new transaction reporting mechanisms and data aggregators. In particular, MiFID II is set to create a consolidated trade tape for Europe’s equities markets that will provide investors with an even view on equities prices and which will set European benchmarks for best-bid-and-offer statistics.

The three main consequences of greater transparency in European capital markets trading will be: the application of equities-like best execution models for other asset classes; changes to client trade reporting and internal sellside trade reporting mandates; and requirements to conform to external price benchmarks. MiFID I established a set of principles for best execution for equities in Europe, which will be expanded to non-equities instruments in MiFID II. However, many non-equities instruments have different structural liquidity dynamics, and they are traded in different ways. Therefore, an expansion of MiFID I’s best execution mandate requires market participants to engage in a rethink of their approach to trade execution on an asset class-by-asset class basis.

Additionally, existing buyside and sellside metrics used to evaluate broker performance on trades or to evaluate the performance of specific traders will be challenged under MiFID II to provide a greater level of insight on the quality of trade execution. The additional benchmark – a consolidated tape – for equities will challenge the veracity of previously-used, broker-specific or client-specific benchmarks.

Navigating to a more transparent world

Based on an assessment of common industry practices across the leading banks, hedge funds, asset managers and technology vendors, GreySpark Partners has observed a variety of MiFID II trade execution issues that are common to them all. For example, when offering their clients TCA and best execution reporting, the companies must evaluate if existing practices are sufficient in the context of the new regulatory framework. In particular, the evaluation needs to ask:

• Are the right instruments covered under MiFID II’s best execution reporting and TCA standards?
• Is the time and trading context captured properly?
• Are all direct and indirect costs captured?
• Are the costs properly categorised and attributed?
• What is the accuracy of the timestamp, and are the time-stamping clocks synchronised?

The availability of new European trade execution benchmarks for equities through the creation of a consolidated tape for each benchmark may challenge the nature of some existing buyside and sellside execution policy methodologies. Specifically, the MiFID II requirements will challenge underlying models for providing and proving best execution reporting and for calculating costs.

Banks should also consider if the frequency at which they distribute TCA information to their clients is sufficient. At the least, the EU regulations specify an annual reporting schedule. But, in the new, data-driven rather than relationship-driven world, annual communication of transactions analysis data is considered as significantly insufficient.

The end of ‘not-the-worst’ execution?

Post-MiFID I, the most common claim regarding the directive’s best execution rules was that the client did not receive the worst-possible execution level – trade execution was done on a price/at-the-cost that was not the worst in the given context of when the trade was made. One of the problems with obtaining the best rather than not-the-worst execution is the lack of reliable, comprehensive pricing benchmarks.

A European consolidated tape would fix that problem. However, it will not be sufficient to provide best execution. This reality emanates from the fact that the quality of the execution can be evaluated fully only after the trade is done, in the context of the market’s movements in reaction to the order, and in the context of all events that occurred during the execution period.

Execution strategies are typically built and selected based on historical information on market behaviour for an instrument, and on the historical outcomes associated with trading it at any given point in time. Therefore, by default, the pre-trade assessment is not universally applicable to all future market scenarios and, as a result, is insufficient to guarantee ultimately the best outcome.

A European consolidated tape would, however, change the benchmark used to evaluate not-the-worst execution, and it will raise the bar for pre-trade TCA or execution advisory to take into account a Europe-wide context for the underlying analytics.

The best-possible tool for use in supporting – but not yet resolving – MiFID II’s goal to create a best execution environment is real-time TCA software. These types of so-called in-trade analytics can advise their users if the original, planned execution strategy is on course to be the best one possible.

A brave new world in the making

However, the development landscape for TCA tools supporting real-time analytics and proof of best execution is uneven. A GreySpark review of the leading TCA providers in 2014 showed that post-trade TCA for equities trading is fully commoditised, with in-trade and pre-trade analytics delivered by 10 out of the 11 equity specialists surveyed.

FX analytics is the second-most sophisticated asset class in terms of real-time TCA maturity, with eight out of 11 equities TCA specialists surveyed by GreySpark seen offering FX post-trade TCA. Out of those eight FX TCA providers, three were seen by GreySpark as offering pre-trade execution advisory tools.

Fixed income is the most difficult asset class for TCA tools to penetrate due to a lower level of electronic trading in, primarily, corporate bonds, and a lower level of overall transparency in the asset class as a whole when compared to equities or FX. Therefore, only two out of 11 vendors surveyed by GreySpark were seen offering post-trade TCA for fixed income products. Meanwhile, pre-trade TCA for fixed income products remains an unexplored area.

There are some emerging technology vendor solutions focusing on FX or on fixed income TCA only. But the leading banks in each market are now also offering or building their own bonds, currencies or interest rates derivatives TCA and execution advisory tools in-house. It is important to emphasise, however, that those tools will only be effective for their client base of users in the context of the liquidity that is accessible through the bank.

As the technology supporting TCA matures and expands across asset classes, incorporating real-time analysis, the EU’s regulatory principle of providing best execution as it is enshrined in MiFID II will move closer to becoming a reality. However, as the end of 2015 approaches, the provision of independent buyside and sellside technology tools and pricing benchmarks making the development of truly robust best execution still seems like a holy grail.

[divider_line]©BestExecution 2015