GETTING YOUR DUCKS IN A ROW.
Silvano Stagni, group head of marketing & research at IT consultancy Hatstand, considers the MiFID Review and asks if you will you be able prove the ‘Best’ in your ‘Execution’?
It is common knowledge that the MiFID Review (MiFID II/MiFIR) extends the scope of the directive to non-equity financial instruments. The review also redefines client classification. Clients are rated by financial instrument. A client may be ‘professional’ for shares, bonds and credit derivatives, but ‘non-professional’ for other types of financial instruments.
The emphasis of the directive has changed. MiFID II/MIFIR provides a definition of best execution by identifying four pillars: price, cost of trading, speed of execution of the order, and the likelihood of the order being executed (liquidity).
There is now an emphasis on proving the quality of the execution. Institutions will have to report on it. Obligations will vary depending on client classification (Non-Professional, Professional and Executive Counterparty). Clients will have the information necessary to assess the quality of execution from a mix of reports provided by Execution Venues and Financial Institutions (FI).
This article describes what a Financial Institution has to provide to its clients. An execution venue, it will have to provide a different type of report. FIs licensed as Organised Trading Facilities (OTFs) or Systematic Internalisers (SI) will have to provide both set of reports.
A Financial Institution reporting obligation will be fulfilled using a report called the “Order Flow and Execution Quality Report”. This report consists of three sections:
- Summary by order type which reports the total percentage of the volume of each order type (see below).
- Top five venues of execution, based on the details of the previous rolling 12 months.
- A data report sorted by order type and execution venue. In this section the volume in each trading venue by order type and any extra information that may have influenced the decision to use that specific execution venue, such as inducements, a close link or discounts, must be stated.
The format of the report as laid out in the consultation paper, has much interesting information both on the principles of best execution and on the report itself.
The top 5 venues receiving a percentage of all orders must be listed. An order should be placed with at least five trading venues whenever possible. MiFID I stated the requirement to distribute orders among multiple trading venues. Whilst the Review mentions ‘five top trading venues’, this could mean ‘at least’ five.
In the current market, this seems easy to achieve with equities but more difficult with non-equity instruments. This is an erroneous perception because:
- In those jurisdictions where MiFID I was extended to bonds (Italy, Germany and Denmark) Multilateral Trading Facilities (MTFs) were set up to deal with secondary trades of highly liquid bonds. Any regulated market could create alternative trading venues for the most liquid non-equity contracts.
- MiFID II/MiFIR defines a fourth type of trading venue, the Organised Trading Facility (OTF), specifically for non-equity trades. This gives every company currently operating a trading platform the option to register as an OTF. It will therefore be possible to have five venues where a financial instrument could be traded.
- Under the terms laid out in the version that was under consultation until early March 2015, all possible ‘execution venues’ will have to be listed (if they are in the top five) such as market makers, OTC, etc. This however may yet change.
Differentiation must be made between a Market Order (an order to buy or sell an investment immediately at the best available current price), a Limit Order (an order to buy or sell an investment at a specified price or better. It cannot be executed if the price set by the investor cannot be met during the period of time when the order is open) and Other Orders. All of this needs to be reported by financial instrument.
The definition of financial instrument needs to be precise enough to reveal differences in order execution behaviours, but aggregated enough to ensure that the reporting obligations on investment firms are proportionate. There is a suggestion to calibrate the classes of financial instruments to include the definitions in Annex I, section C of level 1 MiFID II (list of financial instruments in scope).
Whilst the logic behind this report is straightforward, collecting all the required information and making sure that all ‘the ducks are lined up’ is not. There is a large amount of data to collect and there is also the need to establish the top five execution venues per financial instrument on a 12-month rolling basis. To date, there are no provisions for a transition period, therefore it would be prudent to start capturing the information that will be required sooner rather than later.
A Financial Institution may also have to prepare a second ‘Execution Quality’ report if it is also an ‘Execution Venue’. This applies if it is a Market Maker, if it seeks a licence as OTF or SI, or if it executes OTC trades. The only information specified is that it will have to report on the four pillars of best execution: price, total cost of transaction, speed of execution and likelihood of execution. The requirements for this report are not as clearly defined as the one discussed above.
This of course means more data; data that might not be currently captured. It might therefore be prudent to start reviewing data capture and to discuss whether to seek to be registered as an OTF or SI in anticipation of the imposition of the requirements for the relevant additional reporting.
MiFID II/MiFIR may not be imminent but it is coming. ‘Line up your ducks in a row’ as soon as you can, it will pay off later.