How Do Regulatory Frameworks like Mifid Ii Specifically Address Best Execution for Otc Derivatives?

Concept

The Markets in Financial Instruments Directive II (MiFID II) represents a significant evolution in the regulatory landscape for financial markets within the European Union. Its provisions concerning best execution for over-the-counter (OTC) derivatives introduce a structured and evidence-based approach to a market segment that has historically been characterized by its opacity. The directive’s core principle is to ensure that investment firms, when executing client orders, take all sufficient steps to obtain the best possible result for their clients. This mandate extends unequivocally to OTC derivatives, compelling firms to move beyond legacy practices and implement a more rigorous, data-driven framework for execution.

For OTC derivatives, the application of best execution principles presents unique challenges. Unlike exchange-traded instruments with transparent pricing and centralized liquidity, OTC derivatives are often bespoke, bilateral contracts. Their pricing can be complex and dependent on a variety of factors, including counterparty risk, liquidity, and the specific terms of the agreement.

MiFID II addresses this by requiring firms to establish a comprehensive order execution policy that is tailored to the specific characteristics of OTC instruments. This policy must be more than a mere formality; it is a dynamic operational blueprint that must be demonstrably effective in achieving best execution on a consistent basis.

The directive compels firms to look beyond the headline price of an OTC derivative and consider a broader range of execution factors. These include not only direct costs but also indirect costs such as clearing and settlement fees, speed of execution, likelihood of execution and settlement, and the size and nature of the order. This holistic approach requires a sophisticated understanding of the total cost of execution and the ability to weigh these different factors in a way that is consistent with the client’s best interests. For retail clients, the emphasis remains on total consideration, which is the price of the instrument plus all associated costs.

Strategy

Developing a MiFID II-compliant best execution strategy for OTC derivatives necessitates a fundamental shift in a firm’s operational and technological infrastructure. The transition from “all reasonable steps” to “all sufficient steps” is a critical element of this transformation. It requires firms to not only have a best execution policy in place but also to be able to provide evidence that the policy is consistently followed and that it delivers the best possible outcomes for clients. This involves a multi-faceted approach that encompasses data analysis, venue selection, and ongoing monitoring.

The Execution Policy a Central Component

The execution policy is the cornerstone of a firm’s best execution strategy. It must be a detailed and comprehensive document that clearly articulates the firm’s approach to executing client orders for OTC derivatives. The policy must be tailored to the specific classes of OTC instruments that the firm trades and should identify the execution venues that the firm will use to consistently achieve the best possible results. For OTC derivatives, these “venues” can include systematic internalisers, market makers, and other liquidity providers.

A critical component of the execution policy is the disclosure of the relative importance of the various execution factors. While price is a key consideration, the policy must also explain how other factors, such as costs, speed, and likelihood of execution, are taken into account. The policy must also be transparent about any potential conflicts of interest and the firm’s policy on inducements. Firms must obtain prior consent from their clients for the execution policy and must also obtain express prior consent if they intend to execute orders outside of a regulated market or multilateral trading facility, a common practice in the OTC derivatives market.

MiFID II’s best execution framework for OTC derivatives mandates a shift towards a more quantitative and evidence-based approach to trade execution.

Data and Analytics the Foundation of Best Execution

The ability to capture, analyze, and act on data is fundamental to a successful MiFID II best execution strategy. For OTC derivatives, where pre-trade price transparency can be limited, firms need to gather market data from multiple sources to benchmark the fairness of the prices they receive from liquidity providers. This can involve using data from consolidated tape providers, independent pricing sources, and internal models.

Transaction Cost Analysis (TCA) plays a vital role in this process. TCA enables firms to measure the quality of their execution against a variety of benchmarks and to identify areas for improvement. By analyzing execution data over time, firms can gain insights into the performance of different liquidity providers and execution strategies. This data-driven approach is essential for demonstrating to regulators and clients that the firm is taking all sufficient steps to achieve best execution.

The following table illustrates the key execution factors under MiFID II and their relevance to OTC derivatives:

Venue Selection and Monitoring a Dynamic Process

Under MiFID II, firms must have a clear process for selecting and monitoring the execution venues they use for OTC derivatives. This process should be based on a thorough assessment of the venues’ ability to consistently deliver best execution. Firms are required to regularly review the effectiveness of their venue selection and to make changes as necessary.

The introduction of new trading venues for derivatives, such as Organised Trading Facilities (OTFs), has increased the range of execution options available to firms. OTFs provide a more transparent and competitive environment for the trading of certain types of derivatives, which can help firms to achieve better execution outcomes for their clients.

The following list outlines the key steps in a MiFID II-compliant venue selection and monitoring process for OTC derivatives:

• Initial Due Diligence ▴ Conduct a thorough assessment of potential execution venues, considering factors such as their regulatory status, market share, and execution quality.
• Ongoing Monitoring ▴ Regularly monitor the performance of selected venues using a range of quantitative and qualitative metrics.
• Regular Reviews ▴ Conduct periodic reviews of the firm’s venue selection to ensure that it remains appropriate and effective.
• Documentation ▴ Maintain detailed records of the firm’s venue selection and monitoring process to demonstrate compliance with MiFID II.

Execution

The execution of a MiFID II-compliant best execution framework for OTC derivatives requires a significant commitment of resources and expertise. It is a complex undertaking that involves changes to a firm’s technology, processes, and culture. The following sections provide a detailed overview of the key operational protocols and reporting requirements that firms must implement to comply with the directive.

RTS 27 and RTS 28 the Core of MiFID II’s Transparency Regime

Regulatory Technical Standards (RTS) 27 and 28 are at the heart of MiFID II’s best execution reporting requirements. These standards are designed to increase transparency in the market and to provide investors with the information they need to assess the quality of execution they are receiving from their investment firms.

RTS 27 ▴ Execution Venue Reporting

RTS 27 requires execution venues, including systematic internalisers and market makers, to publish quarterly reports on the quality of their execution. These reports must include a wide range of data, such as:

• Information on the average price, costs, and speed of execution for different types of financial instruments.
• Data on the likelihood of execution for different types of orders.
• Information on the number of orders received and executed.

This data provides investment firms with a valuable source of information for assessing the performance of different execution venues and for making informed decisions about where to route their clients’ orders.

RTS 28 ▴ Investment Firm Reporting

RTS 28 requires investment firms to publish annual reports on their top five execution venues for each class of financial instrument. These reports must also include a qualitative assessment of the execution quality obtained from each venue. The purpose of these reports is to provide clients with greater transparency into how their orders are being executed and to encourage competition between execution venues.

The detailed reporting requirements of RTS 27 and RTS 28 provide a powerful incentive for firms to continuously improve their execution performance.

The following table provides a summary of the key reporting requirements under RTS 27 and RTS 28:

Demonstrating Compliance a Continuous Process

Complying with MiFID II’s best execution requirements for OTC derivatives is not a one-off project. It is an ongoing process that requires continuous monitoring, review, and improvement. Firms must be able to demonstrate to regulators and clients that they have a robust and effective best execution framework in place.

This involves maintaining detailed records of all trades, including the time of execution, the price, and the execution venue. Firms must also be able to provide a clear audit trail that shows how they have complied with their execution policy for each and every trade. The ability to provide this level of transparency is essential for building trust with clients and for meeting the expectations of regulators.

Reflection

The implementation of MiFID II’s best execution framework for OTC derivatives has fundamentally reshaped the operational and strategic landscape for institutional market participants. The directive’s emphasis on transparency, data-driven analysis, and demonstrable compliance has created a more demanding and sophisticated environment for trade execution. For firms that are able to embrace these changes, the rewards can be significant.

By investing in the necessary technology, processes, and expertise, firms can not only ensure compliance with the directive but also gain a competitive advantage in the marketplace. A robust and effective best execution framework can lead to improved execution outcomes for clients, stronger client relationships, and a more resilient and sustainable business model.