With MiFID II looming in Europe in January 2017, attention is being focused on how to implement best execution standards in practice on fixed income execution desks that will be subject to the new regulations. There have been a range of responses to this question from several leading buyside firms and agency execution desks across Europe that were privately surveyed by AxeTrading in the past twelve months. (AxeTrading provides solutions for fixed income electronic trading and automation, including execution management and smart order routing.)
This article aims to broadly summarise these responses, and characterise them in terms of the pending MiFID II ‘best execution’ regulations. In terms of general readiness for the new regulatory standards, this made for some interesting findings.
Firstly, let’s look at the ‘best execution’ provisions of MiFID II:
According to law firm Taylor Wessing: “[Under MiFID II]…Firms will be required to take all sufficient steps to obtain 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 (the "best execution factors") [….]
In the case of execution of orders and decisions to deal in OTC products, the firm must be able to check the "fairness" of the price proposed to the client. […] ESMA has explained that this is to be determined "by gathering market data used in the estimation of the price of such products and when possible by comparing with similar or comparable products.” (Taylor Wessing – ‘What’s changing under MiFID II?’ Feb 2015)
“All sufficient steps…”
The first point to understand is that the concept of ‘best execution’ differs greatly in practice between exchange traded (e.g. equities) and over-the-counter traded (e.g. corporate bonds) instruments. On the OTC markets, the lack of a centralised trade venue such as an exchange, the much greater number of instruments available for trading, and the generally lower per-instrument trading frequency all raise particular challenges to determining what is ‘best execution’ for a fixed income instrument.
The question remains open as to what will be deemed ‘sufficient steps’ in this context by the regulators once MiFID II is implemented. In terms of fixed income order execution, the practicalities of assessing all the available options for execution and of actually executing the trade, will likely play a part in setting the accepted standards. These will depend on the liquidity characteristics of the instrument, the available options for execution open to the trader, general market characteristics (volatility, direction), and taking into account the other ‘best execution factors’. Although this varies by instrument and whether the instrument is mandated for trading on a regulated platform, most of the firms surveyed plan to continue executing fixed income orders using a mix of voice and on-screen sources for price discovery, and OTC trading plus requests-for-quotes for smaller trades. These decisions will usually continue to be left to the trader within the framework of the best execution firm’s policy. This effectively leaves the traders with the responsibility of compliance with the best execution regulations, and being ready to prove ‘best execution’ if challenged.
In practice, at least for the time being, for traders this usually means checking a variety of sources for pricing including on-screen quotes, chat messages, axes/runs and discussing pricing with selected counterparties. Once the order is ready for execution the choice of whether to trade over the phone/chat or electronically, and the trading venue, is usually left to the execution trader.
Under the new regulations, additional pre-trade transparency standards will generate further data which will have to be taken into consideration with each trade, and which will therefore need to be integrated into the traders’ pre-trade workflow.
When asked, few of the firms surveyed expressed complete satisfaction with their current ability to prove all sufficient steps were taken to ensure best execution with every trade. Currently, there remains a strong reliance across most of the firms surveyed on the separate records of phone tapes/chat records as well as the ‘audit trail’ of competing quotes for an electronic trade. Some firms still rely on ‘screen grabs’ or manual entry of competing quotes once a trade is executed. These sources of ‘best execution’ information are generally difficult to aggregate and compare, and it remains to be seen whether this will be sufficient to meet the compliance and reporting standards set by the new regulatory regime.
Though it will be a requirement for OTC order execution under MiFID II, the practical interpretation of the ‘fairness’ of an OTC order execution price is as yet unclear. It has been interpreted as the ability to justify the price by comparison to other relevant data, including trades and/or market pricing and spreads.
Though all firms surveyed were at pains to point out the internal standards they set for best execution, only a small number of the firms surveyed were fully satisfied with their ability to readily demonstrate compliance with the ‘fairness’ of any order execution price if challenged, beyond pointing to price history data and phone tapes/chat history data, which could be a burdensome task. The additional complexity of many possible workflows for executing a fixed income trade only adds to this challenge: in addition to trading over the telephone or chat systems/bulletin boards, fixed income traders have the electronic trading options of routing firm orders, requests-for-quotes, list trading models, auction platforms, and others; even once the decision is taken to execute the trade electronically, which of these offers the best execution mechanism for a given electronic trade and why was it chosen?
In terms of technical capabilities around best execution and reporting, the following were all discussed and responses obtained: Being able to integrate all the traders’ fixed income trading venues and workflows to the internal order management/compliance system was seen as a basic requirement, though not all firms surveyed had this capability in place. Being able to automatically collate all relevant quotes and spreads for a given trade from multiple sources and trading platforms in one screen so that they are readily comparable at the time of execution, as well as classifying these quotes by type and quality (e.g. firm/indicative, how recent etc.) were broadly seen as desirable. Being able to automatically capture all relevant quote data in the ticket with each executed trade to demonstrate ‘best execution’ will become increasingly important under MiFID II; and being able to derive compliance reporting and transaction cost analysis (TCA) from these data were also seen as valuable. Nonetheless, almost none of the firms surveyed had all or most of these capabilities fully in place when surveyed.
Smart Order Routing
Several of the firms surveyed either had implemented, or planned to implement fixed income ‘smart order routing’ as a means of strengthening best execution compliance. (This is defined as an algorithm which automatically directs the routing of an order to a given execution venue or venues based on predefined rules.) This takes away the execution decisions from human traders for applicable trades and thus ensures compliance with the firm’s predefined ‘best execution’ standards at all times. The increasing availability of order-driven electronic trading venues for certain types of fixed income instrument is seen as a prerequisite for the wider adoption of fixed income smart order routing. Although still in its infancy, this is likely to become more of a common feature in fixed income execution in the coming years.
Finally, MiFID II also sets out additional standards for reporting, including executed trades and top five execution venues. The additional reporting burden places practical demands on execution desks, which will have to be met either through manpower or technology. The key to managing this efficiently will be to automate the process as far as possible, and ensure the necessary data is readily available for reporting purposes.
In conclusion, MiFID II is just over one year away from coming into effect, though the state of readiness of a significant number of execution desks that will be affected by the new regulations, is questionable. It’s hard to blame them; the regulations have undergone a number of changes since they were originally proposed. The necessary investment in terms of effort and technology in order to prepare for the changes is significant, and carries additional costs for nearly all involved. Firms have been waiting for clarity before committing to any decisions regarding infrastructure or policy changes.
The available technology has also taken time to adjust to these new requirements. However technology is becoming available to help meet these challenges; firms like AxeTrading have developed solutions to address the needs of the fixed income trading community in the current environment. AxeTrading has developed the first purpose-designed fixed income execution management system in Europe. AxeTrading, based in London, is an award-winning, innovative financial technology (‘FinTech’) firm of experienced fixed income electronic trading professionals, founded in 2009 to deliver technology solutions for the challenges now facing the fixed income trading community.