How Do Regulatory Frameworks like MiFID II View the Use of Hybrid Models for Achieving Best Execution?

Concept

Regulatory frameworks, particularly the Markets in Financial Instruments Directive II (MiFID II), do not explicitly define or approve “hybrid execution models.” Instead, the regulation’s architecture creates the precise environmental pressures that make such models a systemic necessity. The core of MiFID II’s best execution mandate is the requirement for investment firms to take “all sufficient steps” to obtain the best possible result for their clients. This obligation extends beyond mere price to encompass a multi-dimensional array of factors ▴ costs, speed, likelihood of execution and settlement, size, and the intrinsic nature of the order itself.

An execution system designed to satisfy this mandate must be capable of navigating a complex and intentionally fragmented liquidity landscape. This is the operational space where hybrid models function.

A hybrid execution model is an integrated system that dynamically interacts with a spectrum of liquidity sources. It is an architecture, a coherent operational system that combines access to lit markets (like traditional exchanges and Multilateral Trading Facilities), dark pools, and bilateral liquidity channels such as Systematic Internalisers (SIs) and Request for Quote (RFQ) protocols. The system’s intelligence lies in its ability to route orders based on a sophisticated, data-driven logic that weighs the competing best execution factors in real-time. The framework’s view, therefore, is one of implicit endorsement through functional demand.

A firm cannot logically demonstrate it has taken “all sufficient steps” by confining its execution to a single type of venue. The regulation compels firms to build or access systems capable of making intelligent choices across the entire venue landscape, effectively mandating the capabilities that define a hybrid model.

The regulatory framework of MiFID II necessitates hybrid execution models by demanding a verifiable, multi-factor approach to best execution across a fragmented venue landscape.

This perspective moves the conversation from a simple checklist of compliance to a more profound understanding of system design. The question is what kind of execution architecture is required to consistently meet the best possible outcome for a client across a diverse range of market conditions and order types. The answer is a system that can fluidly blend the price discovery and transparency of lit markets with the reduced market impact of dark venues and the principal liquidity offered by SIs.

The regulation, by its very structure, favors systems that possess this adaptability. It is a performance-based mandate, and hybrid models represent the technological and strategic response to that performance challenge.

Strategy

Developing a robust strategy for best execution under MiFID II requires viewing the available liquidity sources as a portfolio of options, each with distinct characteristics. A hybrid model’s core strategic function is to optimize order routing across this portfolio. The intelligence of the system, typically embodied in a Smart Order Router (SOR), is what translates regulatory requirements into an effective execution strategy. This strategy is built upon a deep understanding of how different venues serve the various factors of best execution.

Navigating a Fragmented Liquidity Landscape

MiFID II solidified a market structure composed of diverse and competing execution venues. A successful strategy must treat this fragmentation as an opportunity. The SOR at the heart of a hybrid model does not view a lit exchange, a dark pool, and a Systematic Internaliser as equivalents. It assesses them based on the specific needs of each client order.

• Lit Markets (Exchanges, MTFs) ▴ These venues offer transparent, pre-trade price discovery. The strategy for small, liquid orders in stable market conditions would prioritize routing to these venues to capitalize on competitive pricing. The trade-off is potential information leakage and market impact for larger orders.
• Dark Pools (Dark MTFs) ▴ These venues withhold pre-trade transparency, making them ideal for executing large block orders without signaling intent to the broader market. The strategy here is to minimize market impact and adverse price movement. The risk is that execution may not be guaranteed or that the price obtained might be inferior to the best price available on a lit market at that precise moment.
• Systematic Internalisers (SIs) ▴ An SI is an investment firm that deals on its own account by executing client orders outside of a regulated market or MTF. A hybrid model’s strategy incorporates SIs as a valuable source of principal liquidity. For certain orders, an SI can offer price improvement over the public quote, providing a clear benefit under the “total consideration” test for retail clients. The strategy involves pinging the SI for a quote before exposing the order to other venues.
• Request for Quote (RFQ) Protocols ▴ For less liquid instruments or large, complex orders, an RFQ system allows the firm to solicit quotes from multiple liquidity providers discreetly. This bilateral price discovery mechanism is a key component of a hybrid strategy for asset classes like OTC derivatives and bonds, where continuous lit market liquidity is scarce.

How Do Hybrid Models Balance MiFID II Execution Factors?

The brilliance of a hybrid strategy is its ability to make dynamic, evidence-based trade-offs between the best execution factors. The relative importance of these factors changes depending on the client’s classification (retail or professional), the instrument’s characteristics, and the order’s size. A retail client order, for instance, places primary importance on total consideration (price plus costs), while a large institutional order might prioritize likelihood of execution and minimizing market impact over a marginal price improvement.

The following table illustrates the strategic considerations a hybrid model’s SOR would apply when weighing execution factors against venue types.

A successful execution strategy under MiFID II leverages a hybrid model to dynamically select the optimal venue by weighing the specific, and often competing, best execution factors for each individual order.

This dynamic balancing act is the essence of fulfilling the “all sufficient steps” obligation. It requires a pre-defined, yet flexible, execution policy that can be audited and justified to regulators. The strategy is not static; it is a continuous process of analysis, execution, and review, powered by the data generated from every trade.

Execution

The execution of a MiFID II-compliant strategy through a hybrid model is a function of sophisticated technology, rigorous data analysis, and documented governance. It is where the theoretical balancing of execution factors is translated into tangible, auditable actions. The core components of this execution framework are the Smart Order Router (SOR), Transaction Cost Analysis (TCA), and the firm’s overarching execution policy.

The Smart Order Router Decision Matrix

The SOR is the operational heart of the hybrid model. It is an algorithm that automates the venue selection process based on a pre-programmed decision matrix. This matrix is a detailed representation of the firm’s execution policy, tailored to different asset classes and order types.

It codifies how the firm prioritizes the MiFID II execution factors in practice. A firm must be able to demonstrate to regulators precisely why the SOR routed a specific order in a particular way.

The following table provides a simplified example of an SOR decision matrix for equity orders, illustrating the practical application of the hybrid model.

The Role of Data Transaction Cost Analysis and Governance

MiFID II’s demand for “all sufficient steps” is an evidence-based requirement. A firm cannot simply claim its hybrid model works; it must prove it. This is achieved through a continuous feedback loop driven by Transaction Cost Analysis (TCA).

1. Pre-Trade Analysis ▴ Before an order is sent to the SOR, a pre-trade TCA tool estimates the expected execution cost and market impact based on historical data and current market volatility. This sets a benchmark against which the execution quality will be measured.
2. Post-Trade Analysis ▴ After execution, a detailed TCA report is generated. This report compares the actual execution price against various benchmarks (e.g. arrival price, Volume-Weighted Average Price (VWAP), implementation shortfall). This analysis provides the quantitative evidence of whether the execution outcome was optimal.
3. Policy Governance and Review ▴ The outputs from the post-trade TCA are fed back into a governance process. A best execution committee must regularly review this data to assess the performance of the SOR’s logic and the quality of execution provided by each venue. If a particular dark pool consistently delivers poor fill rates or a lit market shows high price reversion, the SOR’s routing table must be adjusted. This documented process of monitoring, reviewing, and correcting deficiencies is a core tenet of MiFID II compliance.

Under MiFID II, the execution process is a cycle of data-driven analysis, automated routing, and rigorous review, designed to continuously prove and improve the quality of client outcomes.

What Is the Impact of Removing RTS 27 and 28 Reporting?

Regulators in both the UK and the EU have moved to scrap the obligations for firms to produce RTS 27 (from venues) and RTS 28 (from firms) reports. These reports were found to be of limited use to investors and burdensome for firms to produce. This development does not weaken the best execution obligation. It strengthens the focus on a firm’s internal systems and controls.

The removal of these standardized reports means regulators will place even greater emphasis on a firm’s ability to demonstrate, upon request, its own robust, data-driven process for achieving best execution. The quality of a firm’s internal TCA, the sophistication of its SOR, and the rigor of its governance committee become the primary evidence of compliance. The focus shifts from public, standardized reporting to the quality and integrity of the internal execution architecture itself.

Reflection

Is Your Execution Architecture a System or a Series of Steps?

The principles embedded within MiFID II compel a move away from viewing execution as a sequence of discrete tasks. The framework challenges firms to architect a single, coherent system where strategy, technology, and governance are fully integrated. The removal of prescriptive reporting like RTS 28 amplifies this point; the focus is now entirely on the integrity and intelligence of your internal process. How does your firm’s current operational framework stand up to this view?

Does your post-trade analysis directly and dynamically inform your pre-trade strategy, or do the reports serve as a historical record? The objective is to build a living architecture that learns from every execution, constantly refining its logic to prove it is taking all sufficient steps. The ultimate advantage lies in possessing an execution system that is not just compliant, but demonstrably superior in its ability to protect client interests across all market conditions.