MiFID II: Proving Best Execution Is Data Challenge

With the arrival of MiFID II, trade execution will no longer be solely the concern of the trading desk.

It will take a village of compliance, operations, portfolio managers, IT managers and even website designers for financial firms to prove they have met the best execution requirements of the second incarnation of the Markets in Financial Instruments Directive (MiFID II). So warn compliance and operations experts. A recent study of 55 North American and European asset managers published by Liquidnet, operator of a global institutional trading network, showed that fewer than 10 percent of respondents were ready to handle MiFID II. The lack of preparedness isn’t surprising considering the magnitude of the change between the initial and new version of MIFID.

Considering the increased number of trading venues and the need to incorporate more financial instruments into best execution requirements, regulators have decided to raise the bar for investor protection and transparency. For the first time, investment firms will have to report annually on best execution, providing both quantitative and qualitative details. In addition to monitoring of execution outcomes, they will also have to describe what steps were taken to adjust the workflow process when outcomes were suboptimal. So far, ESMA has defined investment firms as fund managers, banks and broker-dealers. The UK’s Financial Conduct Authority has proposed extending MiFID II’s reach to alternative fund managers.

“Compliance managers are typically responsible for regulatory reporting,” explains Joanna Fields, principal of Aplomb Strategies, a New York-based consultancy specializing in regulatory compliance. “However, because of the vast amount of trade details and analysis required to be reported, portfolio managers, traders and IT managers will likely carry most of the workload.” The reason: they are the ones who own the data and will be tweaking front-office systems to keep track of execution quality and correct potential failures. Those systems include order management and execution management systems as well as customer onboarding platforms.

Quantitative Metrics

As of April 2018, financial firms falling under MiFID II’s jurisdiction, must disclose the top five venues in which they trade by value of transactions and additional data for up to 22 asset classes. Those venues include traditional exchanges as well as multilateral trading facilities, organized trading facilities and broker-dealer systematic internalizers. “For small firms, compliance will be relatively straightforward, but as a firm’s trading activity rises and the number of venues also increases, so does the administrative burden,” says John Jannes, director of trading services for data and post-trade processing giant IHS Markit in New York. “Practically speaking, the firm must be prepared to extract trade data from order management systems, make some calculations, populate data fields in human and machine readable formats and place all the information on a public website.”

The list of information that must be disclosed under each category of asset class is extensive. It includes the name of the venue, and the volume of client orders executed on that venue expressed as a percentage of total executed volume of the financial firm. Whether firms access liquidity directly from a venue or wheyther they provide explicit instructions to an executing broker on how to execute an order, they must also disclose passive and aggressive trades in their reporting. Passive orders represent those in which a firm adds liquidity to the market whereas aggressive orders represent those in which it takes liquidity.

“Passive and aggressive orders is a concept that is well-defined for some intrument types such as equities, but less defined or even available for fixed-income instruments,” warns Jannes. “Because financial firms will be required to produce statistics for passive and aggressive behavior even when there is little quantitative data, their compliance managers could be forced to make judgement calls on how to best characterize their trading behavior when compiling public reports.”

Qualitative Analysis

Quantitative data is just the tip of the iceberg in the reporting details required. Financial firms must also publish a summary and a conclusion of analysis statement related to their monitoring of execution quality on the venues where client orders were executed the previous year. Although the reporting is only required once a year, detailed monitoring must occur on an ongoing basis for all trading venues and not just the top five. The financial firm must also publish tables of the top five execution venues ranked by volume and instrument type. The task should give web designers and administrators a lot of overtime.

For some firms it might not be practical or even possible to analyze every single order to determine if best execution was achieved. However, they will still need to verify that their policies take into account all asset classes and investor types. Firms must also check that the policies are correctly applied.

That is why writing summary and conclusion of analysis statements could be the hardest part of the reporting process. “Financial firms must compare their stated policy for best execution for retail and professional clients with the results they have achieved for each asset class,” says Fields. Best execution must still take into account the best possible results such as price, cost, speed, likelihood of execution and size of order. However, firms are allowed to give different weightings to each factor depending on the type of investor involved.

Given the amount of data to be collected and the higher standard of sufficient rather than reasonable effort, the ESMA is allowing firms some leeway. In a question and answer document published in April, the pan-European regulatory agency suggested that some firms might not be required to provide information on passive and aggressive trades in their first year of reporting. Only an analysis of the top five venues, summary and conclusion of analysis statements might be sufficient.

Not only should firms pay close attention to reporting correctly, but also how much effort they have put into analyzing their execution venues. “The most obvious warning sign to regulators would be relying on a single trading venue or a single counterparty for a specific asset class,” explains Fields. “Such a scenario could indicate that the firm did not do its utmost to ensure that its client achieved optimal trading results.” Although it is possible that a quantitiative analysis of best execution results for different venues could drive routing decisions to a single venue, she says, a firm would still have to prove it has established a consistent methodology and implemented a system of governance controls to identify, monitor and change its routing strategy.

“In order to comply with the [best execution] requirement firms must act in the best interests of the client. They must determine whether there are alternative venues available [besides only the single one used],” says ESMA in its recent question and answer document. “In doing so, a firm may for instance benchmark the value of expected aggregate price improvements by adding a venue and comparing the expected outcomes against an assessment of any additional direct, indirect or implicit costs that might be passed onto the client as well as counterparty or operational risks.”

The way a firm executes an order may be just as important as which venue it uses, according to ESMA. That is because different order types such as limit orders or good-till-cancelled orders will generate different results. Likewise, entering an order in one block versus splitting it into multiple orders may also affect the cost of the trade to the investor.

What to Do

As financial firms now plan their budgets for 2018, says Fields, there is no better time for them to start preparing for MiFID II’s reporting requirements. They will need to identify what information is currently available internally and in what format. They must also contact their executing broker-dealers and trading venues to find out when and in what format they will have data available. “A historical quantitative review of how orders are currently routed with a focus on single venues, counterparties and implicit cost analysis would be a good start,” says Fields.

The good news is that there are software systems that can assist with the quantitative reporting requirements of MiFID II. Transaction cost analysis systems can support the ongoing analysis of execution quality for each venue a firm uses and potentially create the tables for the top five trading venues. IHS Markit says that its cloud-based service goes a step further than TCA platforms by accommodating more asset classes and providing a workflow for analyzing, documenting and publishing execution quality on a public website.

However, technology can only go so far, as Fields notes. One critical question financial firms must address is what policies are in place that drive order routing logic for each of 22 product types. Yet another: who within the firm is currently responsible for governance, control and monitoring for best execution requirements. Ideally the right team and a clear ownership process are in place to monitor and analyze routing decisions. If not, firms may need to make some changes — and quickly.

Liquidnet’s study showed that about one-third of the 55 respondents will make changes to the trading workflow, while more than a quarter are investing in technology to ensure a more systematic approach to best execution. Broker-relationships are also being evaluated. About 70 percent of asset managers say they are reviewing new liquidity providers beyond their current brokers and more than two-thirds are no longer choosing where to trade solely based on their broker’s preference.