How Do Firms Quantify Best Execution for Illiquid Corporate Bonds under MiFID II? ▴ Question

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Concept

The mandate to secure best execution for illiquid corporate bonds under the Markets in Financial Instruments Directive II (MiFID II) presents a significant analytical challenge. The directive’s elevation of the standard from “all reasonable steps” to “all sufficient steps” imposes a more rigorous, demonstrable obligation on investment firms. This framework requires a holistic assessment of execution quality, moving beyond the singular pursuit of the best price to a multi-dimensional evaluation encompassing cost, speed, likelihood of execution and settlement, size, and any other relevant consideration.

For liquid asset classes like equities, this quantification is a relatively straightforward exercise, supported by a continuous stream of public data from consolidated tapes. Corporate bonds, however, exist in a fundamentally different market structure.

The universe of corporate bonds is vast and fragmented, with millions of individual ISINs, the majority of which trade infrequently. Unlike equities, where a centralized order book provides a clear, continuous view of liquidity and price, the bond market operates primarily over-the-counter (OTC). This inherent opacity means that for a specific illiquid bond, a recent, relevant trade price may not exist. A bond might not trade for days, weeks, or even months.

Consequently, the concept of a National Best Bid and Offer (NBBO), the cornerstone of equity best execution, is inapplicable. This absence of a single, observable “market price” at the moment of execution compels firms to construct a defensible valuation from disparate data points. The task is to build a robust analytical framework that can produce a fair price benchmark in a data-scarce environment, thereby transforming a qualitative regulatory requirement into a quantitative, evidence-based process.

Quantifying best execution for illiquid bonds is an exercise in constructing a valid price reference in the absence of continuous market data.

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The Structural Impediments to Price Discovery

Understanding the quantification process begins with acknowledging the structural realities of the corporate bond market. Liquidity is not uniform; it is concentrated in a small number of recently issued, large-sized benchmark bonds. For the vast majority of outstanding issues, finding a counterparty is a bespoke process, heavily reliant on dealer networks. This market structure introduces several complexities that any quantification model must address.

First, the reliance on dealer-provided liquidity means that price is often a function of a specific dealer’s inventory or risk appetite at a particular moment. Second, the information leakage associated with sourcing liquidity for a large or particularly illiquid bond can adversely impact the final execution price. A firm’s analytical system must therefore account for the context of the trade, including its size and the prevailing market conditions, to accurately assess the quality of execution. The challenge is not merely to find a price, but to prove that the executed price was the best possible result achievable under the specific circumstances of the order.

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Strategy

A firm’s strategic response to the best execution mandate is encapsulated in its Order Execution Policy. This document is the foundational blueprint that defines the firm’s approach to achieving and verifying the best possible outcome for its clients. It moves beyond a simple statement of intent to a detailed description of the procedures and analytical frameworks that govern the entire trading lifecycle. For illiquid corporate bonds, this policy must be particularly sophisticated, detailing the methodologies for constructing price benchmarks in the absence of observable data and outlining the relative importance of the various execution factors.

The strategy is operationalized across three distinct phases ▴ pre-trade, at-trade, and post-trade analysis. Each phase employs specific tools and data to inform the decision-making process and build a comprehensive audit trail. This systematic approach ensures that execution decisions are not made in a vacuum but are part of a repeatable, defensible, and data-driven process. The ultimate goal is to create a feedback loop where the results of post-trade analysis continuously inform and refine pre-trade strategies and at-trade decisions.

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The Three Pillars of Execution Analysis

A robust strategy for quantifying best execution integrates analysis before, during, and after the trade. Each stage serves a distinct purpose in the overall framework.

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Pre-Trade Analysis the Strategic Foresight

Before an order is placed, a thorough pre-trade analysis is conducted to assess the prevailing market conditions and the liquidity profile of the specific bond. This involves using available data sources to estimate a fair value range and identify potential liquidity providers. Key activities in this phase include:

Liquidity Assessment ▴ Using historical trade data, dealer inventories, and market depth indicators to classify the bond’s liquidity profile. This classification determines the appropriate execution strategy.
Benchmark Construction ▴ Generating a pre-trade benchmark price using evaluated pricing services and comparable bond analysis. This benchmark serves as an initial reference point for the trading desk.
Venue and Protocol Selection ▴ Choosing the optimal execution method, which could range from a broad request-for-quote (RFQ) to a targeted, principal negotiation with a single dealer known to have an axe in the security.

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At-Trade Analysis the Real-Time Discipline

During the execution process, real-time monitoring tools provide the trading desk with live data to guide their decisions. For illiquid bonds, this typically involves the RFQ process, where quotes are solicited from multiple dealers. The at-trade analysis focuses on:

Quote Analysis ▴ Comparing the received quotes against the pre-trade benchmark and against each other. The system analyzes the spread of the quotes, the number of respondents, and the speed of response.
Information Leakage Monitoring ▴ Observing any market data changes that could indicate the RFQ process is impacting the bond’s perceived value.

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Post-Trade Analysis the Evidentiary Foundation

This is the most critical phase for quantification. Post-trade Transaction Cost Analysis (TCA) provides the definitive, evidence-based assessment of execution quality. It involves a detailed comparison of the final execution price against a variety of benchmarks.

The analysis is not a single number but a comprehensive report that provides context and demonstrates that all sufficient steps were taken. The output of this analysis is used for regulatory reporting, client communication, and refining future trading strategies.

Effective post-trade TCA provides a multi-faceted view of execution, comparing the trade against several independent benchmarks to build a robust case for best execution.

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Data Sources for Benchmarking

The credibility of any TCA system rests on the quality and independence of its data sources. Firms must integrate multiple data streams to create a composite view of the market. The following table outlines the primary data sources used for benchmarking illiquid corporate bond trades.

Data Source	Description	Strengths	Limitations
Evaluated Pricing Services (e.g. BVAL, CBBT)	Third-party services that provide daily evaluated prices for millions of fixed-income securities using proprietary models, dealer quotes, and other market data.	Provides comprehensive coverage, even for the most illiquid bonds. Offers an independent, objective reference point.	The price is a model-based estimate, not a firm, tradable price. The accuracy can vary depending on the availability of inputs.
Comparable Bond Data	Trade data from bonds with similar characteristics (e.g. issuer, credit rating, maturity, sector) to the bond being traded.	Grounded in actual market transactions. Reflects the market’s pricing of similar risk profiles.	Defining “comparable” can be subjective. Requires a sophisticated model to adjust for differences between the bonds.
RFQ Platform Data	The quotes received from dealers during the RFQ process for the specific trade.	Provides a direct, trade-specific record of available liquidity and pricing at the moment of execution.	The quotes are only visible to the firm conducting the RFQ and do not represent a market-wide view. Can be influenced by information leakage.
Post-Trade Trace Data	In the US, the Trade Reporting and Compliance Engine (TRACE) provides consolidated post-trade data. European equivalents are developing.	Offers a centralized, transparent record of executed trades.	Data is delayed, and in Europe, the consolidated tape is still evolving. May not have a recent trade for the specific illiquid bond.

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Execution

The execution of a best execution framework for illiquid corporate bonds is a quantitative discipline. It involves the systematic application of analytical models to the available data to produce a defensible assessment of trade performance. This process transforms the strategic principles outlined in the firm’s execution policy into a series of concrete, measurable outputs.

The core of this process is Transaction Cost Analysis (TCA), which, for illiquid instruments, relies on a mosaic of techniques rather than a single benchmark. Each technique provides a different lens through which to view the trade, and together they form a comprehensive picture of execution quality.

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Quantitative Technique Comparable Bond Analysis

When a direct price for an illiquid bond is unavailable, one of the primary methods for constructing a benchmark is to analyze the prices of comparable securities. This technique involves identifying a cohort of bonds with similar risk characteristics and using their recent trade data to infer a fair value for the target bond. The selection of the peer group is critical and is typically automated based on parameters such as:

Issuer and Seniority ▴ Bonds from the same issuer and with the same ranking in the capital structure.
Credit Rating ▴ Securities with identical credit ratings from major agencies.
Maturity and Duration ▴ Bonds with similar maturity dates and interest rate sensitivity.
Sector and Currency ▴ Operating in the same industry and denominated in the same currency.

Once the peer group is established, the system can calculate an average or median yield, spread, or clean price, which is then used as a benchmark for the target bond. Adjustments may be applied to account for minor differences in coupon or maturity.

The following table illustrates a simplified comparable bond analysis for an illiquid bond from a fictional company, “Global Corp.”

Bond (ISIN)	Issuer	Rating	Maturity	Last Price	Benchmark Status
XS1234567890	Global Corp	A+	2035	N/A (Target Bond)	Target
XS1234567891	Global Corp	A+	2034	101.50	Comparable
XS9876543210	Peer Corp	A+	2035	102.10	Comparable
XS9876543211	Global Corp	AA-	2035	103.50	Non-Comparable (Rating)
XS1234567892	Global Corp	A+	2045	98.00	Non-Comparable (Maturity)
Inferred Benchmark Price for Target Bond				~101.80	Calculated

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Quantitative Technique RFQ Process Quantification

For most institutional bond trades, the RFQ protocol is the primary method of execution. Documenting and analyzing the results of the RFQ process is a cornerstone of proving best execution. The TCA system captures every quote received, providing a clear record of the liquidity that was available for the trade. The analysis goes beyond simply selecting the best price; it examines the competitiveness of the auction.

Key metrics calculated from the RFQ data include:

Spread to Best ▴ The difference between the winning quote and the next best quote. A smaller spread indicates a more competitive auction.
Quote Spread ▴ The difference between the highest and lowest quotes received, indicating the range of dealer pricing.
Hit Rate ▴ The frequency with which a particular dealer provides the winning quote.

A detailed analysis of the RFQ process provides a powerful, trade-specific demonstration of the firm’s efforts to survey the available market and achieve the best price.

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Synthesizing the Data a Holistic TCA Report

The final step in the quantification process is to bring all the analytical elements together into a single, comprehensive post-trade TCA report. This report serves as the definitive record of execution quality for a given trade. It presents the executed price alongside multiple benchmarks, providing the context necessary for a fair evaluation. This multi-benchmark approach is crucial for illiquid bonds, as no single reference point is sufficient on its own.

A TCA report would typically summarize the performance of a trade by showing the “slippage” or cost in basis points relative to each benchmark. This allows the firm to demonstrate that even if the price appears unfavorable against one benchmark, it was strong relative to others, painting a complete and defensible picture of the execution quality achieved.

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References

Choi, J. & Huh, Y. (2017). Best Execution in the Bond Markets. Journal of Financial Markets, 34, 56-75.
European Securities and Markets Authority. (2017). Guidelines on MiFID II best execution requirements. ESMA/2017/SGC/234.
Financial Conduct Authority. (2017). Best execution and payment for order flow. PS17/13.
Harris, L. (2015). Trading and Electronic Markets ▴ What Investment Professionals Need to Know. CFA Institute Research Foundation.
International Organization of Securities Commissions. (2018). Regulatory Issues Raised by Changes in Market Structure. Final Report.
Bessembinder, H. & Maxwell, W. (2008). Transparency and the corporate bond market. Journal of Economic Perspectives, 22(2), 217-34.
Asquith, P. Covert, T. R. & Pathak, P. A. (2013). The market for financial adviser misconduct. Journal of Political Economy, 121(1), 92-151.
O’Hara, M. & Zhou, X. A. (2021). The electronic evolution of the corporate bond market. Journal of Financial Economics, 140(3), 659-678.
Tradeweb. (2017). Best Execution Under MiFID II and the Role of Transaction Cost Analysis in the Fixed Income Markets. White Paper.
The Investment Association. (2019). Fixed Income Best Execution ▴ Not Just a Number. Industry Report.

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Reflection

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Calibrating the Execution Framework

The quantification of best execution for illiquid instruments is not a static endpoint. It is a dynamic and evolving discipline. The analytical frameworks and data sources discussed represent the current state of a system designed to impose order on an inherently opaque market. The true strategic advantage lies in the continuous refinement of this system.

Each trade, analyzed through the prism of post-trade TCA, provides new data that informs the next pre-trade decision. This iterative process of analysis, execution, and refinement transforms the regulatory obligation from a compliance exercise into a source of competitive intelligence. The ultimate objective is to build an execution framework that learns, adapts, and consistently delivers superior outcomes in the complex landscape of corporate credit.