MiFID II will significantly up the ante around various aspects of reporting when it goes live on 3rd January 2018, including asset class coverage, trade reporting, transaction reporting, market structure and best execution.
The European Securities and Markets Authority (ESMA) set about ensuring greater protection by introducing the Markets In Financial Instruments Directive (MiFID) in 2007. Its initial focus on was on the equity and primarily electronic markets.
The revisions to this legislation, set out in MiFID II, will bring greater challenges around Best Execution.
The FCA’s thematic review in 2014 highlighted how the regulators want the Best Execution process to work. Firms will have to take all sufficient steps to document their execution processes and show clear, concise procedures when asked to demonstrate how they execute trades when asked by auditors and customers.
The major challenges with Best Execution begins at the point at which the commercial relationship is established between a client and an investment firm.
MiFID recognizes that investors have different levels of knowledge, skill and expertise and therefore the regulatory requirements should reflect this. MiFID does this by placing clients into categories.
- Retail customer (or retail), defined as ‘contrary to’ or as a professional client or eligible counterparty.
- Professional client is “a customer who possesses the experience, knowledge and expertise to make their own investment decisions and properly assess the risks involved”.
- Eligible Counterparty requires excellent knowledge of financial markets and products, and therefore a guarantee waiver of the rules of conduct MiFID. These investment firms, credit institutions and insurance companies, pension funds, central banks and international institutions. Access to this category is not automatic, but the customer must confirm that he wants to be treated as an eligible counterparty.
The most difficult call to make is whether a client is owed best execution. A new, more complex four-fold test is used 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
Given the extreme difficulty for firms to understand whether a client has shopped around, how do you know that they are firmly reliant on you for execution? One approach is to offer all clients best execution.
Overall, there are 17 different reporting scenarios for Investment Firms and Execution venues.
An investment firm placing orders has to produce RTS 28 reports. These show the top five venues and are broken down into the aforementioned client categories.
Meanwhile, execution venues will have to produce RTS 27 reports. Systematic Internalizers (SI), Regulated Markets, Organised Trading Facilities (OTF) and Multi-lateral Trading Facilities (MTF). These reports are quarterly and could run into thousands and thousands of lines.
But best execution reporting is even more complex for execution venues because they have different trading paradigms, for example Regulated Markets (Central Limit Order Book Trading), MTF (RFQ/RFS), OTF (RFQ/RFS,Bi-lateral (Chat,Voice)) and SI (RFQ/RFS,Bi-lateral (Chat,Voice)).
Best Execution Monitoring
With MiFID II, the overarching best execution obligation requires firms to take all sufficient steps to obtain the best possible result.
This must take into account a range of execution factors, when executing client orders or placing orders with (or transmitting orders to) other entities to execute.
This has changed from MiFID I, where firms were only obliged to provide reasonable steps.
It’s been well stated that it’s not one factor that proves best execution. The execution factors become increasingly difficult to prove once you move into the non-equity markets.
The product types are complex and the types of analytics are non-transferable in the large part from the equity markets. Firms will have to deploy a range of new methods to look at these factors.
As an example, this involves looking for proxy products to benchmark executions against or looking at holding times before you respond to an RFQ from a customer. This will require new technology and more sources of data.
Firms will need to know which are the primary markets where instruments are traded and source the appropriate pricing information as liquidity shifts across venues. .
The nature and application of best execution will be under real scrutiny from 3rd January. Firms need to start looking at implementation now and not put this off further.
In relation to the delay of MIFID II in February 2016, the ESMA stated “the reason for the extension lies in the complex technical infrastructure that needs to be set up for the MiFID II package to work effectively.”
There will be no more time. Get moving.