How Did MiFID II Change the Use of RFQ Protocols for Illiquid Assets?

Concept

From Bilateral Handshakes to Mandated Transparency

Prior to the implementation of the Markets in Financial Instruments Directive II (MiFID II), sourcing liquidity for illiquid assets was a fundamentally opaque process, grounded in bilateral relationships. For instruments like thinly traded corporate bonds, bespoke derivatives, or large blocks of equities, the Request for Quote (RFQ) protocol was the primary mechanism. This process involved a buy-side trader discreetly contacting a small, trusted circle of dealers to solicit prices. The protocol’s value was in its containment of information leakage; broadcasting a large or sensitive order to the wider market was a guaranteed way to invite adverse price movements.

The system, however, operated in a regulatory penumbra, with minimal formal requirements for price transparency or a demonstrable audit trail of execution quality. The directive fundamentally challenged this status quo.

MiFID II was engineered to drag these over-the-counter (OTC) activities into a more structured and transparent regulatory framework. The legislation’s core objectives were to enhance investor protection, increase market transparency, and restore confidence in the financial system. For illiquid assets traded via RFQ, this meant the established, relationship-based system had to be systematically re-engineered. The directive introduced stringent best execution requirements, mandating that investment firms take all sufficient steps to obtain the best possible result for their clients.

This was a profound shift from a principle to a demonstrable obligation. A simple phone call or a Bloomberg message to a few dealers was no longer sufficient. Firms now needed to produce a robust, evidence-based record of their decision-making process, justifying why a particular execution venue and set of counterparties were chosen.

MiFID II systematically transitioned RFQ protocols from private, bilateral arrangements into structured, auditable electronic workflows to meet new transparency and best execution mandates.

The New Architectural Mandate

The directive did not outlaw the RFQ protocol; instead, it co-opted it, recognizing its necessity for instruments where a central limit order book (CLOB) would fail due to insufficient liquidity. MiFID II formally recognized RFQ as a valid trading system but imposed new architectural requirements on its use. It facilitated the migration of this activity from purely bilateral exchanges to regulated trading venues, such as Multilateral Trading Facilities (MTFs) and a newly defined category, Organised Trading Facilities (OTFs). This “on-venue” migration was a critical change.

It meant that even for illiquid assets, the process of soliciting quotes had to occur on a platform that could capture and store all relevant data points for regulatory scrutiny. The introduction of pre-trade transparency waivers for large-in-scale (LIS) orders and specific waivers for illiquid instruments acknowledged the sensitive nature of these trades, but the underlying principle remained ▴ execution needed to be formalized and recorded. This created a powerful incentive for the electronification of RFQ workflows, as manual processes became prohibitively inefficient for meeting the new compliance burdens. The result was a systemic move toward platform-based RFQ, where audit trails, timestamps, and price comparisons are inherent to the system’s design.

Strategy

Systematic Internalisers the New Hubs of Liquidity

One of the most significant strategic shifts prompted by MiFID II was the formalization and expansion of the Systematic Internaliser (SI) regime. An SI is an investment firm that deals on its own account by executing client orders outside of a regulated market, MTF, or OTF. Before MiFID II, this activity was widespread but lacked a consistent regulatory definition. The new rules established a quantitative framework for identifying SIs, forcing many large dealers and banks to register as such for specific instruments.

This had a profound impact on RFQ protocols for illiquid assets. SIs became a critical source of non-venue liquidity, but one that was now subject to MiFID II’s transparency and reporting obligations.

Buy-side firms strategically adapted their RFQ processes to incorporate SIs as a primary destination for orders. Instead of a diffuse network of OTC contacts, traders now had a defined universe of registered SIs to which they could direct their quote requests. This structured approach allowed for more efficient liquidity discovery while simultaneously helping to meet best execution requirements. A request sent to multiple SIs via an electronic platform creates a competitive pricing environment and, crucially, generates a detailed electronic audit trail.

This data ▴ capturing which dealers were queried, their response times, the prices offered, and the final execution details ▴ became the raw material for the best execution reports required by regulators. The strategy shifted from relying on informal relationships to leveraging a regulated, multi-dealer electronic ecosystem.

Re-Engineering the Execution Workflow

MiFID II compelled a fundamental re-engineering of the buy-side trading desk’s workflow for illiquid instruments. The mandate for demonstrable best execution necessitated a move away from manual, high-touch processes toward automated, data-centric ones. This involved the adoption of sophisticated Execution Management Systems (EMS) and Order Management Systems (OMS) capable of handling complex, multi-dealer RFQs and capturing the required compliance data.

The new strategic imperative was to create a defensible execution policy. This involved several key components:

• Pre-Trade Analytics ▴ Before initiating an RFQ, firms began using analytical tools to determine the likely liquidity characteristics of an instrument and to select an appropriate group of liquidity providers. This data-driven selection process replaced the informal “rolodex” approach.
• Multi-Dealer Platforms ▴ There was a mass migration to electronic RFQ platforms that provided access to a wide range of dealers, including SIs and on-venue liquidity pools. These platforms became central to the execution process, offering not just connectivity but also the tools for compliance.
• Transaction Cost Analysis (TCA) ▴ Post-trade analysis became far more rigorous. TCA was extended to illiquid assets, with firms analyzing their RFQ execution data to measure performance against benchmarks, assess dealer pricing quality, and refine their execution strategies over time. The electronic audit trail from RFQ platforms provided the high-quality data needed for this analysis.

The table below contrasts the strategic approach to RFQ for illiquid assets before and after the implementation of MiFID II.

Execution

The Modern RFQ Protocol a Procedural Breakdown

The execution of an RFQ for an illiquid asset under MiFID II is a far more disciplined and technologically mediated process than its predecessor. The protocol is designed to ensure compliance at every stage, from the initial decision to trade to the final post-trade reporting. While the core concept of requesting quotes remains, the operational overlay is now substantially more complex and robust.

Executing an RFQ for an illiquid asset is now a structured, evidence-based procedure designed for regulatory compliance and auditability.

A typical workflow on a MiFID II-compliant electronic platform involves a series of distinct, auditable steps:

1. Order Staging and Pre-Trade Checks ▴ The buy-side trader stages an order in their EMS. The system automatically enriches the order with relevant data, including instrument classification (to determine if it is considered liquid or illiquid under MiFID II’s definitions) and size. This initial step determines the applicable transparency rules and potential waivers.
2. Counterparty Selection and Justification ▴ The trader selects a list of dealers to include in the RFQ. Modern platforms integrate with the firm’s best execution policy, often suggesting or requiring a minimum number of counterparties. The selection must be justifiable, based on factors like historical pricing quality, reliability, and specific expertise in the asset class. This process is recorded.
3. RFQ Dissemination ▴ The RFQ is sent electronically and simultaneously to the selected dealers. The platform acts as a centralized communication hub, ensuring all dealers receive the same information at the same time. The system logs the precise time the request is sent and when it is viewed by each recipient.
4. Quote Aggregation and Evaluation ▴ As dealers respond with their prices, the platform aggregates the quotes in real-time on a single screen. This provides an immediate, comparative view of available liquidity. The system displays the quotes alongside relevant metadata, such as the time to respond and any conditions attached to the price.
5. Execution and Confirmation ▴ The trader executes against the chosen quote with a single click. The platform records the execution timestamp, the winning dealer, the price, and the size. An automated trade confirmation is sent to both parties, creating a legally binding record.
6. Automated Reporting ▴ Following execution, the system automatically handles the necessary post-trade reporting obligations. For trades executed on a venue (MTF/OTF), the venue is responsible for the report. For trades executed with an SI, the SI has the reporting obligation. This automation removes a significant manual burden and reduces the risk of reporting errors.

Data the Bedrock of Compliance

The entire MiFID II framework for RFQ rests on the foundation of data. Every action taken during the lifecycle of a trade must be captured, stored, and made available for regulatory review. The level of detail required is extensive, turning every RFQ into a rich dataset for compliance and analysis. The table below outlines the critical data points that a modern execution system must capture to satisfy MiFID II’s requirements for an RFQ on an illiquid asset.

This systematic capture of data has transformed the RFQ protocol from a simple price discovery tool into a core component of a firm’s compliance architecture. The operational discipline imposed by MiFID II, while initially a significant burden, has ultimately led to a more robust, transparent, and defensible process for trading the market’s most challenging assets.

Reflection

The Systematized Edge

The evolution of the RFQ protocol under MiFID II is a clear illustration of regulation as a catalyst for infrastructural change. The directive effectively rendered obsolete the opaque, relationship-centric model for trading illiquid assets, compelling the market to adopt a more systematic and data-driven operational framework. The resulting architecture, built on electronic platforms, regulated venues, and comprehensive data capture, provides a foundation for greater resilience and integrity. The initial challenge of compliance has yielded a more robust system for sourcing liquidity in difficult markets.

Contemplating this transformation invites a deeper consideration of one’s own operational framework. The principles embedded within the MiFID II changes ▴ transparency, evidence-based decision-making, and the leveraging of technology to manage complexity ▴ have applications far beyond regulatory adherence. They represent a paradigm for achieving a sustainable competitive advantage.

The knowledge gained is a component within a larger system of intelligence. The ultimate strategic potential lies in recognizing that a superior operational design is the most reliable path to achieving superior execution outcomes.