How Does MiFID II Change the Burden of Proof for Best Execution?

Concept

From Reasonable Efforts to Demonstrable Proof

The Markets in Financial Instruments Directive II (MiFID II) fundamentally recalibrated the principle of best execution, moving the entire framework from a qualitative assessment of effort to a quantitative, evidence-based mandate. Before this directive, the operative standard was for firms to take “all reasonable steps” to secure the best outcome for a client. This created a degree of subjectivity in compliance.

A firm could define its processes and, provided they appeared logical and were followed, largely satisfy its obligation. The system operated on a presumption of diligence.

MiFID II replaces this standard with the requirement to take “all sufficient steps.” This seemingly subtle change in language imposes a profound shift in the burden of proof. Sufficiency implies a higher, more rigorous, and, most importantly, a demonstrable standard. It is no longer enough to have a well-documented policy; a firm must now quantitatively prove, on an ongoing basis, that its execution strategy consistently delivers the best possible results for clients across a range of prescribed factors.

The responsibility has pivoted from demonstrating procedural adherence to evidencing superior outcomes. The directive effectively tells firms ▴ “Show us the data.”

The core change was the shift from documenting intentions to proving results, making data the ultimate arbiter of compliance.

An Expanded Definition of Execution Quality

The directive expands the universe of factors that constitute the “best possible result.” While price and costs remain central pillars, MiFID II formalizes the importance of speed, likelihood of execution and settlement, size, and the nature of the order. This multi-faceted definition prevents firms from optimizing for a single variable, such as price, at the expense of others that could be more critical to the client’s overall objective. For instance, for a large, illiquid order, the likelihood of execution and minimizing market impact may far outweigh a marginal price improvement.

This holistic view extends the scope of best execution across all asset classes, including equities, bonds, derivatives, and structured finance products, removing the ambiguity that previously existed for non-equity instruments. The directive mandates that the firm’s order execution policy must clearly explain, for each class of financial instrument, how these factors are weighed and which venues are chosen to achieve the desired outcome. This forces a level of granular analysis and strategic forethought that was not explicitly required under the previous regime. The burden of proof now includes justifying the firm’s execution logic for every type of instrument it trades on behalf of clients.

Strategy

Systematizing the Execution Policy

Under MiFID II, the order execution policy transforms from a static compliance document into a dynamic, strategic framework. Firms must engineer a system that not only outlines their approach but also provides a clear, defensible rationale for their execution choices. This requires a granular breakdown by financial instrument class, detailing the specific venues and brokers used and, critically, the factors that guide the selection process for each. A successful strategy involves creating a feedback loop where execution data continuously informs and refines the policy.

A key strategic decision is the weighting of execution factors. The directive requires firms to determine the relative importance of price, cost, speed, and likelihood of execution for different types of orders and clients. For instance, a retail client’s order in a liquid blue-chip stock might prioritize low explicit costs and price improvement.

In contrast, an institutional client’s large block order in a less liquid corporate bond would prioritize likelihood of execution and minimizing information leakage. The strategy must articulate and justify this differentiated approach, moving beyond a one-size-fits-all model.

A firm’s execution policy must evolve from a static disclosure to a living document that guides and is guided by real-world trading data.

This strategic pivot necessitates a forward-looking monitoring process. Firms can no longer rely on periodic, backward-looking reviews. They must implement systems for pre-trade, intra-trade, and post-trade analysis to ensure the execution policy is effective in real-time.

This involves monitoring execution quality against internal benchmarks and the performance of selected venues. Any material changes to the execution arrangements, such as the addition or removal of a key venue that impacts execution quality, must be promptly communicated to clients.

The New Era of Transparency and Disclosure

MiFID II introduces two pivotal reporting requirements that operationalize the new burden of proof ▴ RTS 27 and RTS 28 reports. These mandates create a strategic imperative for data collection, analysis, and public disclosure, fundamentally altering the competitive landscape.

RTS 27 Reports ▴ These are quarterly reports published by execution venues (like exchanges and market makers) that provide detailed data on execution quality. The reports include information on prices, costs, and the likelihood of execution for individual financial instruments. Investment firms must use this publicly available data to compare and benchmark the performance of their chosen venues against the broader market. This creates a data-driven basis for venue selection and review.

RTS 28 Reports ▴ These are annual reports published by investment firms themselves. In these reports, firms must disclose the top five execution venues they used for each class of financial instruments, both for retail and professional clients. They must also provide a qualitative summary of the execution quality obtained. This public disclosure makes a firm’s execution practices transparent to clients and regulators, creating accountability and competitive pressure to demonstrate high-quality outcomes.

The table below illustrates the strategic shift in reporting and data requirements.

Execution

Building the Evidentiary Framework

Executing a MiFID II-compliant best execution strategy requires building a robust evidentiary framework grounded in data. This is an operational undertaking that integrates technology, data analysis, and governance. The objective is to create a defensible record that proves “all sufficient steps” were taken. This process can be broken down into several key operational stages.

1. Data Capture and Aggregation ▴ The foundation of the framework is the ability to capture comprehensive data for every order. This includes not just the executed trade details but also the entire lifecycle of the order ▴ timestamp of receipt, routing decisions, quotes received from different venues, and reasons for choosing a particular execution path. For Request for Quote (RFQ) workflows, all solicited quotes must be recorded, not just the winning one. This data must be aggregated from various internal systems (OMS, EMS) and external sources (venues, brokers).
2. Transaction Cost Analysis (TCA) ▴ Post-trade TCA is the core analytical engine for proving best execution. Firms must move beyond simple price comparisons. A sophisticated TCA model analyzes execution prices against a variety of benchmarks (e.g. Arrival Price, VWAP, TWAP) to quantify performance. The analysis must account for both explicit costs (commissions, fees) and implicit costs (market impact, slippage). The output of this analysis provides the quantitative evidence to assess the effectiveness of the execution policy.
3. Monitoring and Review ▴ The evidentiary framework is not a one-time project. It requires continuous monitoring. Firms must establish a formal governance process, often overseen by a dedicated committee, to review TCA reports and other execution quality data regularly. This review process must assess the performance of execution venues, brokers, and internal execution strategies. The findings of these reviews must be documented, and any necessary adjustments to the execution policy must be implemented and recorded.
4. Reporting and Justification ▴ The final stage is the ability to produce clear, comprehensive reports for both regulatory and client requests. This includes the generation of the public RTS 28 report and the ability to respond to ad-hoc inquiries from competent authorities with detailed evidence backing up execution decisions. The documentation must be clear enough to demonstrate to a regulator that the firm’s choices were not just reasonable, but sufficient to achieve the best possible outcome.

A Quantitative View of Execution Quality

To satisfy the burden of proof, firms must translate their execution performance into quantifiable metrics. The table below provides a simplified example of a TCA report that a firm might use to review its execution quality for a specific class of instruments, in this case, large-cap European equities.

This type of analysis allows a firm to make data-driven decisions. For example, Venue B shows positive slippage, indicating price improvement, and low costs, making it a strong performer. Venue A has negative slippage, indicating some market impact, but the overall performance is still strong.

Broker C, used for more difficult, high-touch orders, shows higher slippage and costs, but the positive reversion suggests it is effective at minimizing long-term market impact for those specific trades. This level of quantitative detail is essential for justifying execution choices to regulators and demonstrating that the firm is actively monitoring and optimizing its performance.

Reflection

Beyond Compliance a System of Intelligence

The shift in the best execution mandate under MiFID II prompts a fundamental re-evaluation of a firm’s operational architecture. The requirements for data-driven proof and continuous monitoring should be viewed as components of a larger system of market intelligence. The capacity to collect, analyze, and act upon high-quality execution data provides more than regulatory compliance; it offers a distinct competitive advantage.

Firms that successfully integrate this data feedback loop into their trading DNA are better positioned to understand market microstructure, refine their execution strategies, and ultimately deliver superior results for their clients. The burden of proof, therefore, becomes an opportunity to build a more sophisticated and effective trading enterprise.