Can a Firm Rely Solely on RFQs to Satisfy Its MiFID II Best Execution Obligations?

Concept

The Markets in Financial Instruments Directive II (MiFID II) establishes a comprehensive regulatory framework within the European Union, and one of its central tenets is the obligation of best execution. This principle requires investment firms to take all sufficient steps to obtain the best possible result for their clients when executing orders. The framework is designed to enhance transparency, efficiency, and fairness in financial markets.

The best execution obligation is not a monolithic concept; it is a dynamic requirement that adapts to the specific circumstances of each trade. A firm’s adherence to this principle is assessed against a range of execution factors, which include not only price and costs but also speed, likelihood of execution and settlement, size, and the nature of the order.

The Request for Quote Protocol

The Request for Quote (RFQ) protocol is a method of trade execution where a firm solicits quotes from a select group of liquidity providers. This bilateral price discovery mechanism is particularly prevalent in markets for less liquid or more complex financial instruments, such as over-the-counter (OTC) derivatives and large blocks of securities. In an RFQ process, the firm seeking to execute an order on behalf of a client will send a request to multiple dealers, who then respond with their best bid or offer.

The firm then selects the most favorable quote and executes the trade. This process allows for price competition among a targeted set of market makers, which can be advantageous for instruments that do not have continuous, transparent pricing on a public exchange.

Interaction with MiFID II

The MiFID II framework explicitly acknowledges the RFQ protocol as a valid execution method. However, the use of RFQs does not automatically satisfy the best execution obligation. The directive mandates that firms must have a clear and comprehensive order execution policy that outlines how they will achieve the best possible results for their clients. This policy must be disclosed to clients, and firms must obtain their consent.

When a firm uses an RFQ process, it must be able to demonstrate that this method was the most appropriate choice for that specific order and that it took all sufficient steps to achieve the best outcome. This includes a careful selection of the liquidity providers invited to quote, a thorough evaluation of the quotes received, and a clear audit trail of the entire process.

A firm’s reliance on the RFQ protocol is permissible under MiFID II, but it necessitates a robust framework to justify its use and prove that the best possible outcome for the client was achieved.

The European Securities and Markets Authority (ESMA) has clarified that the requirement to take “all sufficient steps” under MiFID II represents a higher standard than the “all reasonable steps” obligation under the previous MiFID I regime. This elevated standard means that firms must proactively ensure that their execution arrangements are designed to consistently deliver the best results. For RFQ-based execution, this implies a continuous monitoring of the quality of quotes received from liquidity providers and an ongoing assessment of whether the RFQ process itself remains the optimal execution strategy for a given class of instruments.

Strategy

A firm’s decision to rely on the RFQ protocol as a primary execution method must be a strategic one, deeply embedded within its overall order execution policy. This strategy must be justifiable not only to clients but also to regulators. The core of this strategy revolves around demonstrating that for certain types of orders, the RFQ process is superior to other available execution methods, such as trading on a lit exchange, using an algorithmic trading strategy, or accessing a dark pool.

Justifying the RFQ Approach

The strategic justification for using RFQs typically centers on the characteristics of the financial instruments being traded. For highly liquid, standardized instruments, a lit exchange with a central limit order book often provides the most competitive pricing and transparent execution. However, for other instruments, the RFQ model presents distinct advantages.

• Illiquid Securities ▴ For bonds, derivatives, and other instruments with low trading volumes, there may not be a continuous stream of bids and offers on a public exchange. In such cases, an RFQ allows a firm to actively seek out liquidity from dealers who specialize in these instruments.
• Large Orders ▴ Executing a large order on a lit exchange can have a significant market impact, moving the price against the client before the entire order is filled. An RFQ allows a firm to discreetly source liquidity for the entire block, potentially at a single price, thus minimizing slippage.
• Complex Instruments ▴ For structured products or multi-leg options strategies, an RFQ is often the only practical way to obtain a price for the entire package. These instruments are not typically traded on standard exchanges.

Comparative Analysis of Execution Methods

A comprehensive best execution strategy involves a clear understanding of the trade-offs between different execution venues and methods. The following table provides a comparative overview:

The Role of the “legitimate Reliance Test”

In the context of RFQ trading where a firm acts as a principal (trading on its own account), MiFID II carries forward a concept from its predecessor known as the “legitimate reliance test”. This four-fold test helps determine if a client is legitimately relying on the firm to provide best execution. The factors considered are:

1. Who initiates the transaction ▴ If the firm approaches the client with a specific trade idea, the client is more likely to be relying on the firm’s expertise.
2. Market practice ▴ In markets where it is common for clients to “shop around” and solicit quotes from multiple dealers, there is less expectation of reliance on a single firm.
3. Relative market transparency ▴ The less access a client has to pricing information, the more they will rely on the firm to provide a fair price.
4. The nature of the relationship ▴ How the firm presents its services to the client can influence the client’s expectations.

A firm’s strategy for RFQ execution must take this test into account, particularly when dealing with less sophisticated clients. For professional clients who are actively soliciting quotes from multiple dealers, the firm’s best execution obligation may be more easily satisfied. However, for retail clients, the bar is significantly higher.

Execution

The operational execution of an RFQ-based strategy under MiFID II requires a meticulous and well-documented process. It is insufficient to simply choose the best price from a handful of quotes. A firm must be able to demonstrate, on an ongoing basis, that its entire execution process is designed to achieve the best possible result for its clients. This involves robust pre-trade, at-trade, and post-trade procedures.

Pre-Trade Considerations

Before an RFQ is even sent, a firm’s execution process should begin. This involves several key steps:

• Venue Selection ▴ The firm’s order execution policy must detail the factors used to select the liquidity providers who will be included in the RFQ process. This selection should be based on objective criteria, such as the quality of pricing, the likelihood of execution, and the creditworthiness of the counterparty. This list of providers should be regularly reviewed and updated.
• Instrument Analysis ▴ For each order, the firm should assess whether an RFQ is the most appropriate execution method. This analysis should be documented, especially for orders that could potentially be executed on other venues.
• Client Communication ▴ The firm must ensure that the client has consented to the firm’s order execution policy, which should clearly explain the circumstances under which an RFQ process will be used.

At-Trade Execution and Monitoring

During the RFQ process itself, the firm must maintain a clear and auditable record of its actions. This includes:

• Full Audit Trail ▴ The firm must capture all relevant data points for each RFQ, including the time the request was sent, the liquidity providers it was sent to, the quotes received, and the time of execution.
• Fairness of Price ▴ For OTC products, MiFID II explicitly requires firms to check the fairness of the price proposed to the client. This can be done by comparing the received quotes to other available pricing sources, such as consolidated tape providers or independent valuation services.
• Monitoring Liquidity Provider Behavior ▴ Firms should monitor the performance of their liquidity providers. This includes tracking metrics such as response times, quote competitiveness, and rejection rates. This data can be used to refine the list of approved liquidity providers.

Under MiFID II, the burden of proof lies with the investment firm to demonstrate that its execution process, including the use of RFQs, is consistently delivering the best possible results for its clients.

Post-Trade Analysis and Reporting

The best execution obligation does not end with the trade. MiFID II introduces significant post-trade analysis and reporting requirements.

Firms must regularly analyze the quality of their executions and make this information public. For firms that rely heavily on RFQs, this analysis should include a comparison of the execution quality achieved through the RFQ process versus other potential execution methods. This can be achieved through Transaction Cost Analysis (TCA), which compares the execution price to various benchmarks.

Ultimately, a firm cannot rely solely on the RFQ protocol to satisfy its MiFID II best execution obligations without a comprehensive and demonstrable system for ensuring the best possible outcome for its clients. This system must encompass all stages of the trade lifecycle, from pre-trade analysis to post-trade reporting, and must be supported by robust data capture and analysis capabilities.

Reflection

The reliance on a Request for Quote protocol within a MiFID II framework is a testament to the enduring tension between bespoke liquidity solutions and the regulatory drive for centralized transparency. The directive does not outlaw such protocols; it assimilates them, demanding a higher standard of proof and a more sophisticated operational architecture. A firm’s ability to continue leveraging the benefits of RFQs ▴ discretion, size, and access to specialized liquidity ▴ is now directly proportional to its investment in the systems of record-keeping, data analysis, and comparative analytics.

The question evolves from “Can we use RFQs?” to “Can we build and maintain the evidentiary framework that justifies their use?” This places the burden squarely on the firm’s technological and compliance infrastructure. The future of best execution will be defined not by the choice of a single execution method, but by the intelligence of the overarching system that selects, monitors, and validates the optimal path for every client order.