Over a year has passed since the introduction of new best execution requirements under MiFID II, but for many buy-side firms the difficulties and costs of complying with these rules have only continued to grow. Of course, the intention behind MiFID II is to create additional safeguards in order to protect the market and its participants from a repeat of the 2008 financial crisis. The architects of the Directive may even have expected that the new rules would be relatively straightforward to implement, particularly with many instruments having already been pushed onto lit, centrally-cleared exchanges under EMIR and MiFIR. But we now know that the new requirements have created an additional layer of complexity for most market participants, not just those few that may have been failing to achieve best execution in the first place.
Best execution can be difficult to demonstrate to both clients and regulators. While execution factors such as price and speed did not change under MiFID II, the new directive states that firms must now be able to provide evidence that they took ‘all sufficient steps’ to achieve best execution. In addition, ESMA’s technical advice also calls for participants to check the fairness of the price proposed to their clients if they made the decision to deal in OTC products. This requires them to obtain the market data used to estimate the price of these instruments and then to show how they compare to similar alternatives. The UK’s regulatory body, the FCA, has even gone a step further in its interpretation of the rules, tying the concept of ‘best execution’ to other factors, such as conduct, remuneration and conflicts of interest.
Viewed through a regulatory lens
For firms with clients who have very simple execution requirements or, at the other end of the spectrum, clients who wish to deal in esoteric or complex products, under the remit of MiFID II seeking to execute these orders with only a limited list of venues or counterparties may no longer be considered best practice. MiFID II standards RTS 27 and 28 require firms to disclose their top five execution venues and to have obtained data from each that demonstrates the quality of the execution provided. On paper this appears to be reasonable, but in practice it only seems to create more questions than answers.
For example, are firms now expected to enter into relationships with an expansive list of brokers after years of streamlining their counterparty lists? The collateral and margin this would require, along with the administration resources it would take to maintain those various trading accounts, makes this unachievable for most.
How Outsourced Trading Can Supplement Best Execution
For buy-side firms wishing to fulfill their best execution requirements while keeping costs under control, an emerging best practice is to engage with an outsourced trading firm, a specialist provider of execution services. Having an independent, conflict-free third party to expand ones reach to the sell-side may fulfill the regulatory requirements to a far greater extent than trying to go it alone, as such a provider is likely to have relationships already in place with a wide range of counterparties, sell-side firms and liquidity providers.
It is of course essential that any specialist provider engaged has no ‘skin in the game’ itself, in order to remove any potential conflict of interest. To be unconflicted, the specialist provider should not be affiliated with any broker, bank or venue when executing orders on a client’s behalf. And to achieve the best results, it should use a team of expert traders that can look at available market intelligence and use their experience to identify sources of natural liquidity before entering an order into the market. Not only does finding a matching buyer or seller eliminate the spread cost between bid and offer prices, but this is also best practice in terms of helping reduce market impact.
For a buy-side firm, supplementing their execution by using a specialist outsourced provider such as Tourmaline, itself a client of over 375 brokers globally, eliminates the incremental costs of adding multiple sell-side relationships. By offering an agnostic view of liquidity sources and available market information, such a specialist provider is able to offer an unparalleled ability to achieve every aspect of the mandated ‘execution factors’, and also prove this to the regulators, through reporting requirements such as RTS 27 and 28, and to their clients, through detailed transaction cost analysis (TCA).
Leveraging both outsourced and/or supplemental trading expertise can help institutional clients to better achieve best execution, manage costs and fulfill their fiduciary duty to their clients.
Many thanks to Sam Tyfield of Vedder Price for providing valuable input to this article