Concept
The Illiquid Labyrinth
Demonstrating best execution for an illiquid security to a professional client is a complex undertaking. It moves the conversation beyond the familiar territory of high-frequency, transparent equity markets into a domain characterized by opacity, fragmented liquidity, and negotiated outcomes. For a professional client, the standard of “best execution” is not a simple check-the-box exercise satisfied by achieving the best available price on a lit exchange.
Instead, it represents a rigorous, evidence-based process that substantiates every decision made in the pursuit of an order’s optimal outcome. This process acknowledges that for illiquid instruments ▴ such as certain corporate bonds, structured products, or shares in a small-cap company ▴ the “best” result is a carefully calibrated balance of multiple, often competing, factors.
The core of the challenge lies in the very nature of illiquidity. Where liquid markets offer a continuous stream of data and a centralized view of supply and demand, illiquid markets are often silent and dispersed. There is no single screen that displays the definitive price. Liquidity may be found in disparate, unconnected pools, accessible only through direct relationships and careful negotiation.
Consequently, the firm’s duty shifts from one of simple order routing to one of diligent, methodical search and discovery. The professional client understands this labyrinthine environment. What they require from their firm is not a guarantee of a perfect price but a transparent, defensible, and repeatable methodology for navigating it. They need to see the map, understand the chosen path, and be confident that the firm has the systems and expertise to chart the most effective course under the prevailing conditions.
Best execution in illiquid markets is proven through a documented, systematic process of discovery and judgment, not by a single price point.
Beyond Price the Execution Quality Factors
For professional clients, the concept of best execution expands significantly beyond the singular focus on price and cost that often dominates retail considerations. While total consideration remains a vital component, the execution strategy for an illiquid asset must weigh a broader set of qualitative and quantitative factors. The firm must demonstrate that it has considered these elements in their totality, assigning a relative importance to each that aligns with the client’s stated objectives and the specific characteristics of the order.
These execution factors form a multi-dimensional matrix of decision-making. A large order in an illiquid security, for instance, may prioritize minimizing market impact over immediate price. A slow, careful execution that prevents signaling the client’s intent to the wider market may yield a far superior overall result than an aggressive order that moves the price unfavorably. Similarly, the likelihood of execution becomes a paramount concern.
In a thin market, the certainty of completing a trade, even at a slightly less advantageous price, can be more valuable than chasing an elusive “perfect” price that may never materialize. The firm’s ability to articulate this trade-off, supported by market intelligence and a clear rationale, is central to demonstrating its value. This nuanced approach requires a sophisticated operational framework capable of capturing not just the “what” (the final price) but the “why” (the strategic decisions) behind the execution.
- Price and Cost The ultimate price paid or received and all associated explicit costs, such as fees and commissions. For OTC instruments, this involves checking the fairness of the price by gathering market data and comparing with similar products.
- Speed and Likelihood of Execution The probability of successfully completing the order at the desired size without undue delay. This is critical in markets where liquidity is episodic.
- Size and Market Impact The capacity to execute the full size of the order without causing adverse price movements. This often involves breaking up the order or accessing liquidity discreetly.
- Nature of the Order and Security The unique characteristics of the instrument itself, including its complexity, the credit quality of the issuer (for debt), and any covenants or restrictions.
- Certainty of Settlement The likelihood that the trade will settle smoothly without counterparty failure, a greater concern in bilateral OTC markets.
Strategy
The Pre Trade Intelligence Framework
A robust strategy for executing illiquid securities begins long before the order is sent to the market. The pre-trade phase is the cornerstone of a defensible best execution process. It is here that the firm lays the groundwork for the entire execution, transforming an abstract client request into a concrete, actionable plan. This phase is centered on intelligence gathering and strategic formulation.
The first step is a deep analysis of the security itself and the prevailing market conditions. This involves more than just looking at recent trade data, which may be sparse or non-existent. It requires a qualitative assessment ▴ understanding the issuer, the sector, recent news, and the likely holders of the security. For a professional client, demonstrating this deep dive is the first piece of evidence that the firm is acting with due diligence.
Following this initial analysis, the firm must develop a clear execution strategy. This is not a one-size-fits-all plan; it is tailored to the specific order and client objectives. The strategy document should articulate the chosen approach, whether it be a high-touch strategy involving manual negotiation with multiple counterparties, a low-touch approach using an algorithmic strategy designed to minimize impact, or a hybrid model. It must also define the appropriate benchmarks for success.
For an illiquid bond, the benchmark might be a spread to a reference government bond or a comparison against a composite pricing source, with a clear explanation of why that benchmark was chosen. This pre-trade documentation serves as a critical audit trail, forming the baseline against which the final execution can be judged. It is the firm’s formal hypothesis of how to achieve the best outcome, and every subsequent action should flow logically from it.
Venue and Counterparty Selection a Systematic Approach
With a pre-trade strategy in place, the next critical step is the selection of execution venues and counterparties. For illiquid securities, this is rarely a simple choice of routing to a single exchange. The firm must demonstrate that it has surveyed the available liquidity landscape to identify the most suitable destinations for the order.
This requires a comprehensive and up-to-date understanding of the market structure for that particular asset class. The firm’s execution policy should detail the universe of potential venues it considers, and for any given trade, it must be able to justify why certain venues were selected and others were not.
The Request for Quote (RFQ) process is a common and powerful tool in this context, particularly for OTC instruments like bonds and derivatives. A firm can demonstrate best execution by showing a systematic and competitive RFQ process. This involves sending the request to a sufficient number of relevant counterparties to generate competitive tension and ensure a fair price. The number and choice of counterparties should be justifiable based on their known activity and expertise in the specific security.
The system must capture all quotes received, including the time they were received and their duration. This creates a clear, time-stamped record of the price discovery process. Below is a comparison of potential execution pathways for an illiquid security.
A defensible execution strategy is built on a systematic survey of the fragmented liquidity landscape, not on habit or convenience.
| Pathway | Description | Primary Advantage | Key Consideration | Best Suited For |
|---|---|---|---|---|
| High-Touch Desk | Manual handling by experienced traders who use their relationships and expertise to source liquidity through direct negotiation. | Ability to find hidden liquidity and negotiate complex terms for very large or sensitive orders. | Process can be slower and is highly dependent on individual trader skill. Requires extensive documentation of conversations and rationale. | Large block trades, highly sensitive orders, and securities with no electronic market. |
| Multi-Dealer RFQ Platform | Electronic systems that allow the firm to send a request for quote to multiple dealers simultaneously. | Creates a competitive, auditable environment for price discovery. Efficient and transparent. | The quality of the outcome depends on the number and suitability of the dealers included in the RFQ. Potential for information leakage if not managed correctly. | Standardized OTC instruments like corporate bonds and swaps where a pool of dealers exists. |
| Dark Pools / Block Trading Venues | Anonymous trading venues that allow firms to post large orders without displaying them publicly, minimizing market impact. | Reduced information leakage and potential for price improvement at the midpoint of a lit market spread. | Liquidity can be intermittent. There is a risk of adverse selection if trading with more informed participants. | Large orders in securities that have some degree of public market trading but are still relatively illiquid. |
| Systematic Internaliser (SI) | A firm that uses its own capital to execute client orders. The SI provides a quote against which the client can trade. | Potential for fast execution and price certainty, as the firm is dealing with a single counterparty. | Prices must be checked for fairness against the broader market. The client is reliant on the SI’s pricing quality. | Orders of a size that the SI is willing to absorb onto its own book. |
Adapting Transaction Cost Analysis for the Illiquid World
Transaction Cost Analysis (TCA) is the primary tool for the post-trade assessment of execution quality. However, standard TCA methodologies, which rely on benchmarks like Volume-Weighted Average Price (VWAP) or Arrival Price from continuous lit markets, are often inadequate for illiquid securities. A firm must demonstrate a more sophisticated approach to TCA, one that acknowledges the unique challenges of these instruments. The analysis must be multi-faceted, incorporating both the quantitative data that was collected and the qualitative judgments that were made.
For an illiquid bond, for example, the TCA report would not simply compare the execution price to a non-existent VWAP. It would instead:
- Benchmark against multiple sources Compare the execution price against composite pricing feeds (e.g. from Bloomberg, Refinitiv), the quotes received during the RFQ process, and the prices of any recent trades in the same or similar securities.
- Document the rationale for the timing Explain why the trade was executed at a particular time, referencing the pre-trade analysis of market conditions.
- Analyze the “cost of not trading” For some orders, especially those where the client has a strong need for liquidity, the analysis might include an assessment of the risk or cost of failing to execute the order.
- Incorporate qualitative feedback Include commentary from the trader on the market tone, the difficulty of sourcing liquidity, and the nature of the negotiations. This narrative provides crucial context that raw numbers cannot.
By presenting this comprehensive TCA report to the professional client, the firm is not just showing them a result. It is providing a complete narrative of the trade, substantiating the strategy with data and demonstrating that the execution process was logical, diligent, and designed to achieve the best possible outcome within the constraints of the market.
Execution
The Evidentiary Dossier a Procedural Guide
The execution phase is where strategy translates into auditable action. To demonstrate best execution for an illiquid security, a firm must assemble a comprehensive evidentiary dossier for each trade. This is not merely a compliance exercise; it is the final product that proves the firm’s value to the professional client.
The dossier should be a self-contained record that allows a third party to reconstruct the entire lifecycle of the order and conclude that the firm acted reasonably and in the client’s best interest at every stage. The process of building this dossier must be systematic and embedded within the firm’s Order Management System (OMS) and Execution Management System (EMS) to ensure consistency and completeness.
The following steps represent a procedural guide for compiling this dossier:
- Step 1 Order Inception and Pre-Trade Analysis The process begins the moment the client order is received. The system must log the order’s characteristics ▴ security, size, any specific client instructions (e.g. limit price, desired timing). Immediately following, the trading desk must produce and attach a formal pre-trade analysis document. This document must assess the security’s liquidity profile, identify potential execution venues and counterparties, and propose a specific execution strategy with a clearly defined benchmark.
- Step 2 Market Sounding and Venue Selection This step documents the “reasonable diligence” taken to find the best market. If an RFQ is used, the system must log which dealers were solicited, the exact time of the request, and a justification for their selection. If a high-touch approach is used, traders must contemporaneously log all conversations with potential counterparties, noting any indications of interest, price talk, and the rationale for proceeding with a specific counterparty.
- Step 3 The Competitive Quote Record For RFQ-based executions, this is the core of the price discovery evidence. The system must capture every quote received in response to the request. This record must be immutable and time-stamped, showing the price, size, and duration of each quote. The dossier must clearly show the winning quote and provide a reason for its selection (e.g. best price, largest size, only firm quote).
- Step 4 Execution and Rationale The exact time of execution must be recorded, along with the final price and size. A “trader’s blotter” entry should be made, providing a concise narrative of the execution. This entry should explain why the final execution represents the best possible result, referencing the pre-trade strategy and the quotes received. For example ▴ “Executed full size at 99.50 with Counterparty B. This was the best price received from our 5-dealer RFQ panel and was 0.25 points inside the pre-trade benchmark composite price.”
- Step 5 Post-Trade Analysis and Reporting The final component is the TCA report. As detailed in the strategy section, this report must be tailored to the illiquid nature of the security. It should be automatically generated where possible, pulling data from the previous steps, and then supplemented with qualitative commentary from the trading desk. This report is the ultimate deliverable to the client, summarizing the entire process and presenting a clear, data-backed case for best execution.
Quantitative and Qualitative Execution Factors in Practice
A firm’s execution policy must define the criteria it uses to achieve the best possible result. For professional clients dealing in illiquid securities, this requires a nuanced balancing of multiple factors. The firm must be able to demonstrate, on a trade-by-trade basis, how it weighed these factors. The following table provides a detailed, practical framework for the application and documentation of these factors, forming a key part of the evidentiary dossier.
| Execution Factor | Application in Illiquid Markets | Evidence to Record in Dossier | Example Narrative for Client |
|---|---|---|---|
| Price | The price is evaluated not in isolation, but relative to a range of data points gathered during a rigorous price discovery process. | – All quotes received from RFQ process. – Screen captures of composite pricing (e.g. BVAL, CBBT). – Record of recent trades in the same or similar securities. | “The execution price of 101.25 was the highest of the seven firm quotes we received and was 0.5 points above the composite indication at the time of trade.” |
| Costs | All explicit costs, including any venue fees, settlement charges, or commissions, are clearly disclosed and factored into the net price. | – Fee schedule of the execution venue. – Explicit commission charged. – Calculation of the net price to the client. | “The total explicit cost for this transaction was 5 basis points, resulting in a net price of 101.20 for your account.” |
| Speed | Speed is often secondary to minimizing market impact. The focus is on the timeliness and appropriateness of the execution, not raw velocity. | – Timestamp of order receipt. – Timestamps of all RFQ communications. – Timestamp of final execution. – Trader notes on market conditions influencing timing. | “We executed the order over a 30-minute period to align with our pre-trade strategy of patient execution, which we believe prevented adverse price movement.” |
| Likelihood of Execution | In thin markets, this can be the most important factor. The strategy may prioritize a firm quote from a reliable counterparty over a slightly better but indicative quote. | – Record of all quotes, clearly differentiating between “firm” and “indicative.” – Trader notes on the perceived reliability of each counterparty. | “While we received an indicative quote 0.10 points higher, we chose to execute with Counterparty X as they provided a firm, actionable quote for the full size, ensuring completion of your order.” |
| Size & Market Impact | The ability to execute the client’s desired size without signaling intent and causing the market to move away. This often dictates the entire execution strategy. | – The pre-trade strategy document outlining the plan to manage impact. – Comparison of execution price to pre-trade price levels. – Post-trade analysis of market movements following the execution. | “By utilizing a high-touch approach and splitting the order into two blocks, we successfully executed the full size with minimal market impact, as evidenced by the stable price of the security post-trade.” |
The ultimate proof of best execution is an immutable, time-stamped audit trail that justifies every decision from order receipt to final settlement.
Case Study Execution of an Illiquid Corporate Bond
To illustrate the process, consider a professional client, an asset manager, placing an order to sell €20 million of a 7-year corporate bond issued by a non-rated, private European manufacturing company. The bond trades infrequently, with the last reported trade occurring two weeks prior.
1. Pre-Trade ▴ The firm’s fixed-income desk receives the order. The pre-trade analysis notes the bond’s illiquidity, the large order size relative to typical volume, and the lack of a credit rating.
The proposed strategy is a multi-dealer RFQ to a curated list of 8 dealers known to specialize in unrated European corporate debt, combined with a high-touch approach to one dealer known to have an axe (a standing interest) in the issuer. The benchmark is set as the interpolated spread over the 7-year German Bund, based on a basket of similarly-profiled but more liquid industrial bonds.
2. Price Discovery ▴ The RFQ is sent electronically via the firm’s EMS. Simultaneously, a senior trader calls the high-touch contact.
The EMS logs the following electronic bids ▴ Dealer A ▴ 98.10, Dealer B ▴ 98.05, Dealer C ▴ 97.90, Dealer D ▴ No Bid, Dealer E ▴ 98.15 (for €10m only), Dealer F ▴ 98.00. The trader logs the verbal bid from the high-touch dealer at 98.20 for the full €20m size.
3. Execution Decision ▴ The evidence is clear. The highest bid is 98.20 from the high-touch dealer.
It is also for the full size, satisfying the likelihood of execution and size factors. The trader notes in the system ▴ “Executing full €20m at 98.20 with Dealer G. This represents the best and only firm bid for the full size, is 5bps better than the best electronic bid, and achieves the client’s goal of a clean exit from the position.” The execution is completed and time-stamped.
4. Post-Trade Dossier ▴ The client receives a report containing:
- The pre-trade analysis and strategy document.
- A log of all 8 dealers contacted and the 7 bids received (including “No Bid” and the partial size).
- The execution record showing the time, price (98.20), size, and counterparty.
- A TCA report showing the execution price was favorable compared to the pre-trade benchmark spread and all other bids received.
This comprehensive dossier leaves no ambiguity. It demonstrates a logical, diligent, and evidence-based process designed to achieve the best possible outcome, providing the professional client with complete transparency and validating the firm’s execution capabilities.
References
- Autorité des Marchés Financiers. (2007). Guide to best execution. AMF.
- European Securities and Markets Authority. (2007). Best Execution under MiFID Questions & Answers. ESMA/2007/231.
- Financial Industry Regulatory Authority. (n.d.). 5310. Best Execution and Interpositioning. FINRA.
- UBS Financial Services Inc. (2023, January). Best Execution of Equity Securities. UBS.
- TRAction Fintech. (2023, February 1). Best Execution Best Practices.
- Lehalle, C. A. & Laruelle, S. (Eds.). (2013). Market Microstructure in Practice. World Scientific.
- O’Hara, M. (1995). Market Microstructure Theory. Blackwell Publishers.
- Harris, L. (2003). Trading and Exchanges ▴ Market Microstructure for Practitioners. Oxford University Press.
Reflection
From Obligation to Operational Alpha
The framework for demonstrating best execution in illiquid markets transcends mere regulatory compliance. It represents a fundamental pillar of a firm’s operational capability and its fiduciary promise to a professional client. Viewing this process through the lens of a “Systems Architect” reveals that a robust, evidence-based execution framework is not a cost center but a source of demonstrable value, or “operational alpha.” It is the tangible output of a well-designed system of intelligence, technology, and expertise.
Consider your own operational framework. Does it treat the documentation of illiquid trades as a retrospective, compliance-driven task, or as a proactive, value-generating process? A truly superior system does not simply record what happened; it actively shapes better outcomes.
It equips traders with the pre-trade intelligence to formulate smarter strategies, provides them with efficient pathways to diverse liquidity, and captures the resulting data in a way that proves its own efficacy. The evidentiary dossier is the ultimate testament to this system’s quality.
Ultimately, the confidence a professional client places in a firm is not built on a single successful trade. It is forged through the consistent, transparent, and intelligent application of a process. The ability to deliver a complete, coherent, and data-rich narrative for every illiquid trade is what transforms the abstract duty of best execution into a lasting client relationship and a powerful competitive advantage.
Glossary
Professional Client
Illiquid Security
Illiquid Markets
Execution Strategy
Best Execution
Minimizing Market Impact
Market Impact
Illiquid Securities
Pre-Trade Strategy
Execution Policy
Request for Quote
Rfq Process
Quotes Received
Price Discovery
Transaction Cost Analysis
Execution Price
Tca Report
Pre-Trade Analysis
Evidentiary Dossier
