Concept
The Core Mandate of Execution
The Markets in Financial Instruments Directive II (MiFID II) establishes a comprehensive regulatory framework for financial markets in the European Union. A central pillar of this directive is the principle of “best execution,” which obligates investment firms to take all sufficient steps to obtain the best possible result for their clients when executing orders. This mandate applies to a wide range of financial instruments, including over-the-counter (OTC) derivatives, and covers activities such as executing orders, providing portfolio management, and receiving and transmitting orders. The fundamental objective is to ensure investor protection and promote market efficiency.
However, the application of this principle is not monolithic; it is carefully calibrated based on the classification of the client. MiFID II distinguishes primarily between “retail” and “professional” clients, recognizing their differing levels of experience, knowledge, and ability to assess risk. This distinction is the critical starting point for understanding the nuanced application of best execution requirements.
Delineating Client Categories
The classification of a client as either retail or professional is a determinative step that shapes the entire client relationship, including the nature of the best execution duty owed by the firm. Retail clients are afforded the highest level of protection under MiFID II. This category generally includes individuals who are presumed to lack the financial expertise of institutional investors. Consequently, the regulatory requirements are more prescriptive for this group to safeguard their interests.
Professional clients, on the other hand, are presumed to possess the experience, knowledge, and expertise to make their own investment decisions and properly assess the risks involved. This category typically includes entities such as credit institutions, investment firms, insurance companies, and large undertakings that meet specific criteria related to their balance sheet, net turnover, or own funds. The directive acknowledges that these clients can take on more responsibility for their investment outcomes, which in turn allows for a more flexible application of the best execution rules.
The essence of MiFID II’s best execution is a tiered system of protection, where the level of regulatory oversight is inversely proportional to the client’s presumed financial sophistication.
The Foundation of Best Execution
The overarching obligation for both client types is for firms to take “all sufficient steps” to achieve the best possible result. This is a significant change from the “all reasonable steps” language of the original MiFID, indicating a higher bar for compliance. The “best possible result” is not simply about achieving the best price for a single transaction. Instead, it is a more holistic concept that takes into account a range of “execution factors.” These factors include not only price but also costs, speed, likelihood of execution and settlement, size, nature of the order, and any other consideration relevant to the execution of the order.
The way these factors are prioritized and balanced is a key area where the requirements for retail and professional clients diverge. This structured flexibility allows firms to tailor their execution strategies to the specific needs and objectives of different client types, while still operating within a robust regulatory framework designed to protect all investors.
Strategy
Prioritizing the Execution Factors
For retail clients, the best execution calculus is heavily weighted towards “total consideration.” This metric represents the sum of the financial instrument’s price and all associated execution costs. These costs can include execution venue fees, clearing and settlement fees, and any other expenses directly related to the execution of the order. The emphasis on total consideration provides a clear and quantifiable benchmark for assessing whether a firm has achieved the best possible result for its retail clients.
While other factors like speed and likelihood of execution are still relevant, they are generally considered secondary to the overall cost-effectiveness of the transaction. This approach reflects the regulatory assumption that retail clients are primarily focused on achieving the most favorable net price for their investments.
In contrast, when dealing with professional clients, investment firms have greater discretion in determining the relative importance of the various execution factors. The firm must still take into account the characteristics of the client, the order, the financial instrument, and the potential execution venues, but it is not bound by the same prescriptive focus on total consideration. For a professional client, factors such as speed of execution, the likelihood of executing a large or illiquid order, or the desire to minimize market impact might take precedence over achieving the absolute lowest cost.
This flexibility allows firms to develop more sophisticated and tailored execution strategies that align with the specific objectives of their professional clients. For instance, a professional client executing a large block trade might prioritize minimizing information leakage over securing a fractionally better price.
The strategic divergence in best execution lies in the shift from a cost-centric model for retail clients to a multi-faceted, objective-driven approach for professional clients.
The Role of the Execution Policy
An investment firm’s order execution policy is a critical document that outlines how it will meet its best execution obligations. This policy must be provided to clients and, in the case of retail clients, a clear and easily understandable summary is required. The policy must detail, for each class of financial instrument, the different venues where the firm executes client orders and the factors that influence the choice of venue.
For retail clients, the policy must clearly explain how the firm will ensure that total consideration is prioritized. For professional clients, the policy can be more nuanced, reflecting the different ways in which the execution factors might be weighted based on the client’s specific instructions or the nature of the order.
The following table illustrates the key differences in how execution policies are typically structured for retail versus professional clients:
| Policy Component | Retail Client Focus | Professional Client Focus |
|---|---|---|
| Primary Objective | Achieving the best possible “total consideration” (price + costs). | Achieving the best possible result based on a balanced assessment of all execution factors, as determined by the client’s objectives. |
| Execution Factor Weighting | Price and costs are paramount. Other factors are secondary. | The relative importance of factors (price, cost, speed, likelihood of execution, etc.) can be varied based on the specific order and client instructions. |
| Venue Selection | Venues are selected based on their ability to consistently provide the best total consideration. | Venue selection can be influenced by a wider range of factors, including liquidity, anonymity, and the ability to handle complex orders. |
| Client Instructions | While a firm must follow specific client instructions, the default assumption is a focus on total consideration. | Firms can accommodate a wider range of specific instructions that may prioritize factors other than cost. |
Request for Quote and Legitimate Reliance
In the context of Request for Quote (RFQ) trading, where a firm provides a quote to a client on its own account, the application of best execution has historically been subject to a “legitimate reliance test.” This test, developed under the original MiFID, considers factors such as who initiated the transaction, market practice, and the relative price transparency of the market to determine whether the client is legitimately relying on the firm to protect its interests. While MiFID II has broadened the scope of best execution, this test remains a relevant consideration, particularly for professional clients. For retail clients, the presumption is almost always that they are relying on the firm, and therefore best execution applies. For professional clients, especially in markets where it is common practice to “shop around” for quotes, the expectation that a single firm will provide the best possible result may be diminished.
Execution
Operationalizing the Execution Framework
The operational execution of MiFID II’s best execution requirements demands a robust and well-documented infrastructure. Investment firms must not only establish a comprehensive order execution policy but also implement effective arrangements to monitor and review its application. This involves a continuous cycle of assessment to ensure that the chosen execution venues and strategies are consistently delivering the best possible results for clients. For retail clients, this typically involves a more quantitative analysis, focusing on metrics related to total consideration.
Firms will often use post-trade analysis and benchmarking against external reference prices to verify the fairness of the prices achieved. Any identified deficiencies in the execution arrangements must be promptly corrected.
For professional clients, the monitoring process can be more qualitative, taking into account the broader range of execution factors that may have been prioritized. The review process might involve assessing the effectiveness of a particular strategy in minimizing market impact or achieving a high fill rate for a large order. The key is that the firm must be able to demonstrate that its execution arrangements are designed to achieve the best possible result as defined by the client’s objectives and the firm’s execution policy. This requires a more sophisticated approach to data capture and analysis, as well as a clear audit trail to justify the execution decisions made.
Effective execution under MiFID II is a dynamic process of continuous monitoring, analysis, and adaptation, tailored to the specific protection levels afforded to different client types.
Disclosure and Transparency Requirements
MiFID II introduced significant new reporting and disclosure requirements aimed at increasing transparency in the execution process. These requirements differ in their application to retail and professional clients. One of the most significant is the requirement for firms to provide retail clients with a summary of their execution policy in a clear and easily digestible format. This is not explicitly required for professional clients, who are expected to be able to understand the full policy document.
Furthermore, firms must obtain the prior consent of their clients to the execution policy. For retail clients, this is a critical step in ensuring they are aware of how their orders will be handled.
Another key difference lies in the treatment of orders executed outside of a trading venue (e.g. a regulated market or multilateral trading facility). When a firm intends to execute a retail client’s order outside of a trading venue, it must provide a specific warning and obtain the client’s prior express consent. This consent can be general or specific to a particular transaction. For professional clients, while disclosure is still required, the process is generally less prescriptive, reflecting their greater understanding of the potential risks and benefits of off-venue execution.
The following list outlines some of the key operational differences in executing orders for retail versus professional clients:
- Policy Documentation ▴ Retail clients must be provided with a summary of the execution policy, in addition to the full policy document.
- Client Consent ▴ While consent to the execution policy is required for all clients, the process is often more explicit and detailed for retail clients.
- Off-Venue Execution ▴ Retail clients require a specific warning and prior express consent for orders to be executed outside of a trading venue.
- Reporting ▴ While all firms must publish annual reports on their top five execution venues, the information provided for retail and professional client orders must not be mixed.
The Technological Imperative
The increased complexity of best execution under MiFID II has placed a significant emphasis on technology. Firms need sophisticated order and execution management systems to route orders to the appropriate venues, monitor execution quality, and capture the data necessary for regulatory reporting and internal review. For retail clients, these systems are often geared towards automated execution strategies that prioritize cost efficiency.
For professional clients, the technology needs to be more flexible, allowing for the use of advanced order types, algorithmic trading strategies, and access to a wider range of liquidity pools, including dark pools and systematic internalisers. The ability to customize execution strategies and demonstrate compliance through detailed data analysis is a critical technological challenge for firms serving professional clients.
The following table provides a high-level comparison of the technological requirements for serving retail and professional clients under MiFID II’s best execution framework:
| Technological Capability | Retail Client Focus | Professional Client Focus |
|---|---|---|
| Order Routing | Automated routing to venues that consistently offer the best total consideration. | Smart order routing that can be configured to prioritize different execution factors (e.g. speed, liquidity, market impact). |
| Execution Algorithms | Simpler algorithms focused on achieving a target price or minimizing costs. | A wider range of sophisticated algorithms (e.g. VWAP, TWAP, implementation shortfall) to manage complex orders and minimize market impact. |
| Data Analysis and Reporting | Systems to track and analyze total consideration, and to generate the required regulatory reports for retail clients. | Advanced transaction cost analysis (TCA) tools to measure performance against a variety of benchmarks and to provide detailed execution quality reports to clients. |
| Venue Access | Access to a range of lit markets and other venues that can provide competitive pricing. | Access to a broad universe of liquidity, including dark pools and systematic internalisers, to source liquidity for large or illiquid orders. |
References
- “Best Execution Under MiFID II.” PwC, 2017.
- “Guide for drafting/review of Execution Policy under MiFID II.” Nasdaq, 2017.
- “Summary of the Best Execution Policy for Retail Clients.” Societe Generale, 2018.
- “Complying With MiFID 2 Best Execution.” Dentons, 2017.
- “Best Execution Policy.” Collins Sarri Statham Investments, 2018.
Reflection
Beyond Compliance a Framework for Superior Execution
The intricate web of best execution requirements under MiFID II presents a significant operational challenge for investment firms. The distinctions between the duties owed to retail and professional clients are not merely administrative hurdles; they represent a fundamental call to develop a more sophisticated and client-centric approach to execution. Viewing these regulations solely through the lens of compliance is a missed opportunity. Instead, they should be seen as a blueprint for building a superior execution framework ▴ one that is not only compliant but also a source of competitive advantage.
The Strategic Value of a Differentiated Approach
The ability to effectively differentiate execution strategies for retail and professional clients is a hallmark of a mature and well-run investment firm. For retail clients, this means leveraging technology and scale to deliver consistent, low-cost execution. For professional clients, it means providing a more consultative and flexible service, with access to a wider range of tools and liquidity sources.
The firm that can master both of these disciplines will be well-positioned to attract and retain a diverse client base. The data and analysis required for MiFID II compliance can also be a valuable source of insight, helping firms to refine their execution strategies, identify new sources of liquidity, and ultimately, deliver better outcomes for their clients.
The Unending Pursuit of the Optimal Outcome
The concept of “best execution” is not a static target but a dynamic and evolving process. Market structures change, new technologies emerge, and client expectations shift. The firms that will thrive in this environment are those that embrace a culture of continuous improvement, constantly questioning their assumptions and seeking out new ways to enhance their execution capabilities. The regulations provide the minimum standard; the true leaders will go beyond this, using the principles of best execution as a guide in their unending pursuit of the optimal outcome for every client and every order.
Glossary
Investment Firms
Possible Result
Best Execution
Mifid Ii
Retail Clients
Under Mifid
Professional Clients
Execution Factors
Execution Strategies
Total Consideration
Professional Client
Market Impact
Order Execution Policy
Retail versus Professional Clients
Execution Policy
Their Execution
Execution under Mifid
