How Does MiFID II Change the Definition of Best Execution for Illiquid Assets?

Concept

The implementation of the Markets in Financial Instruments Directive II (MiFID II) represents a fundamental recalibration of the principles governing institutional trading, particularly for assets characterized by low liquidity. The directive moves the definition of best execution from a generalized obligation to a granular, evidence-based framework. This shift compels investment firms to transition from a philosophy of “all reasonable steps” to the more demanding standard of “all sufficient steps.” For illiquid assets, this change is particularly profound. The directive acknowledges that for such instruments, which include certain over-the-counter (OTC) derivatives, structured finance products, and thinly traded bonds, the headline price is only one component of a complex execution equation.

The core of this evolution lies in the directive’s insistence on a holistic and demonstrable process. Firms are now required to consider a wider array of execution factors beyond just price and cost. These include speed, likelihood of execution and settlement, order size, and the nature of the transaction itself.

This multi-faceted approach is designed to address the unique challenges posed by illiquid instruments, where the act of trading can itself impact the market price and where the certainty of settlement is a primary concern. The directive effectively codifies the reality that for these assets, the “best” outcome is a carefully calibrated balance of competing priorities, where the avoidance of adverse market impact can be as valuable as achieving a marginal price improvement.

MiFID II elevates the best execution standard, demanding a systematic and provable approach to securing the optimal outcome for clients, especially in complex and illiquid markets.

Furthermore, MiFID II introduces a significant data and transparency mandate that underpins the new best execution regime. Investment firms are required to establish and implement a detailed order execution policy that is not only disclosed to clients but also rigorously monitored and reviewed. This policy must articulate, for each class of financial instrument, the different execution venues a firm utilizes and the factors that guide the choice of venue. For illiquid assets, which are often traded OTC, this necessitates a systematic approach to sourcing liquidity and benchmarking the fairness of quoted prices.

Firms must be able to demonstrate, through robust data analysis, that their execution strategies are consistently delivering the best possible results for their clients over time. This requirement for ex-ante and ex-post monitoring transforms best execution from a point-in-time obligation to a continuous, data-driven process of optimization.

Strategy

Adapting to the heightened best execution standards of MiFID II for illiquid assets requires a strategic overhaul of a firm’s trading infrastructure and operational workflows. The directive’s emphasis on “all sufficient steps” necessitates a move away from legacy, relationship-based trading practices toward a more systematic and quantifiable approach. A successful strategy is built on three pillars ▴ a dynamic execution policy, a multi-venue approach to liquidity sourcing, and a sophisticated data analytics capability for both pre-trade analysis and post-trade verification.

Developing a Dynamic Execution Policy

Under MiFID II, a firm’s order execution policy can no longer be a static document. It must be a living framework that adapts to changing market conditions and the specific characteristics of each order. For illiquid assets, this means the policy must explicitly account for the unique challenges these instruments present. The policy should detail the specific procedures for handling large or complex orders in illiquid markets, including the criteria for selecting an execution strategy, such as using a request-for-quote (RFQ) protocol versus working an order over time to minimize market impact.

The policy must also define the relative importance of the various execution factors for different types of illiquid assets. For example, for a large block trade in a thinly traded corporate bond, the likelihood of execution and the potential for information leakage may be more critical than achieving the absolute best price. The policy should provide a clear rationale for these weightings, enabling the firm to justify its execution decisions to both clients and regulators. This dynamic approach ensures that the firm’s execution strategy is always aligned with the client’s best interests, as defined by the holistic criteria of MiFID II.

What Is the Role of Multi Venue Liquidity Sourcing?

A key strategic response to MiFID II is the development of a comprehensive and systematic approach to liquidity sourcing. For illiquid assets, which are often traded bilaterally or on a limited number of venues, this presents a significant challenge. Firms can no longer rely on a small group of trusted counterparties.

Instead, they must be able to survey the entire available market to find the best possible execution outcome. This requires connectivity to a diverse range of liquidity sources, including traditional exchanges, multilateral trading facilities (MTFs), organized trading facilities (OTFs), and systematic internalisers (SIs).

The table below illustrates a sample framework for assessing and selecting execution venues for an illiquid corporate bond, in line with MiFID II’s requirements.

Implementing a Robust Data Analytics Framework

The data requirements of MiFID II are extensive and form the bedrock of the best execution regime. Firms must have the systems and processes in place to capture, store, and analyze a vast amount of trading data. This includes not only the details of their own trades but also market data from the various execution venues they use. This data is essential for both pre-trade analysis and post-trade monitoring.

A successful MiFID II strategy for illiquid assets hinges on transforming the trading process into a data-driven, systematic, and continuously optimized operation.

Before a trade is executed, firms should use their data analytics capabilities to assess the available liquidity and potential execution costs across different venues. This pre-trade analysis helps traders make informed decisions about where and how to execute an order. After the trade, a rigorous post-trade analysis, often referred to as Transaction Cost Analysis (TCA), is required.

TCA involves comparing the execution quality of a trade against various benchmarks to determine whether the best possible result was achieved. For illiquid assets, this analysis must be nuanced, taking into account the specific market conditions at the time of the trade and the inherent challenges of trading in a low-liquidity environment.

Execution

The execution of a best execution framework for illiquid assets under MiFID II is a complex undertaking that requires a significant investment in technology, processes, and expertise. It involves a fundamental re-engineering of the firm’s trading operations, from order inception to post-trade analysis. The following provides a detailed operational playbook for implementing a MiFID II-compliant best execution framework for illiquid assets.

The Operational Playbook

Achieving best execution for illiquid assets is a multi-stage process that must be meticulously documented and consistently applied. The following steps provide a high-level roadmap for firms to follow:

1. Order Inception and Pre-Trade Analysis ▴ Upon receiving a client order for an illiquid asset, the first step is to conduct a thorough pre-trade analysis. This involves:
   • Instrument Classification ▴ Classify the asset based on its liquidity profile, complexity, and the client’s specific instructions. This classification will determine the appropriate execution strategy.
   • Liquidity Discovery ▴ Utilize all available tools and data sources to identify potential sources of liquidity. This may include internal crossing opportunities, exchange order books, RFQ platforms, and direct dealer relationships.
   • Cost Estimation ▴ Estimate the total cost of execution, including explicit costs (commissions, fees) and implicit costs (market impact, spread). This analysis should be based on historical data and real-time market conditions.
2. Execution Strategy Selection ▴ Based on the pre-trade analysis, select the most appropriate execution strategy. This decision should be guided by the firm’s order execution policy and should balance the competing priorities of price, cost, speed, and likelihood of execution. For illiquid assets, this may involve:
   • Request for Quote (RFQ) ▴ For large or complex orders, an RFQ process can be used to solicit competitive quotes from a select group of dealers. This helps to minimize information leakage and can lead to better pricing.
   • Algorithmic Trading ▴ For orders that need to be worked over time, algorithmic trading strategies can be used to minimize market impact. These algorithms can be calibrated to the specific liquidity characteristics of the asset.
   • Direct Dealer Negotiation ▴ In some cases, direct negotiation with a dealer may be the most effective way to execute a large block trade in an illiquid asset.
3. Order Execution and Monitoring ▴ Once an execution strategy has been selected, the order is executed. Throughout the execution process, the trade should be monitored to ensure that it is proceeding as planned and that the execution quality is in line with expectations. Any deviations should be documented and addressed in real-time.
4. Post-Trade Analysis and Reporting ▴ After the trade is completed, a comprehensive post-trade analysis must be conducted. This involves:
   • Transaction Cost Analysis (TCA) ▴ Compare the execution price against relevant benchmarks to assess the quality of the execution. For illiquid assets, these benchmarks may need to be customized to reflect the specific market conditions at the time of the trade.
   • Venue Analysis ▴ Analyze the execution quality provided by different venues to identify trends and areas for improvement. This analysis is used to inform the firm’s venue selection decisions in the future.
   • Client Reporting ▴ Provide clients with detailed reports on the execution quality they have received. This transparency is a key requirement of MiFID II and helps to build client trust and confidence.

Quantitative Modeling and Data Analysis

A robust quantitative framework is essential for implementing a MiFID II-compliant best execution framework for illiquid assets. This framework should include models for estimating execution costs, assessing market impact, and benchmarking execution quality. The table below provides an example of a TCA report for a hypothetical trade in an illiquid corporate bond.

How Does Technology Integration Support Best Execution?

The successful execution of a MiFID II best execution framework for illiquid assets is heavily reliant on technology. Firms must have a sophisticated and integrated technology stack that can support the entire trading lifecycle, from pre-trade analysis to post-trade reporting. Key components of this technology stack include:

• Order Management System (OMS) ▴ The OMS is the central hub for managing client orders. It should have robust capabilities for order handling, routing, and execution.
• Execution Management System (EMS) ▴ The EMS provides traders with the tools they need to execute orders effectively. It should offer connectivity to a wide range of liquidity sources and support a variety of execution strategies, including algorithmic trading and RFQ.
• Data Analytics Platform ▴ A powerful data analytics platform is essential for conducting pre-trade and post-trade analysis. It should be able to process large volumes of data in real-time and provide traders with actionable insights.
• Reporting Engine ▴ The reporting engine is used to generate the various reports required by MiFID II, including client reports and regulatory filings. It should be flexible and configurable to meet the specific needs of the firm.

The integration of these systems is critical for creating a seamless and efficient workflow. Data should flow freely between the OMS, EMS, and data analytics platform, providing traders with a holistic view of the market and their own trading activity. This integration enables firms to automate many of the manual processes associated with best execution, freeing up traders to focus on value-added activities, such as developing sophisticated trading strategies and managing client relationships.

Reflection

The implementation of MiFID II has fundamentally reshaped the landscape of institutional trading, particularly for illiquid assets. The directive’s rigorous requirements for best execution have compelled firms to move beyond traditional, relationship-based trading practices and embrace a more systematic, data-driven approach. This transition, while challenging, presents a significant opportunity for firms to enhance their execution capabilities and deliver superior results for their clients. The journey toward a fully compliant and optimized best execution framework is ongoing.

It requires a continuous process of refinement and adaptation, as market structures evolve and new technologies emerge. The firms that will succeed in this new environment are those that view best execution as a core component of their value proposition and invest in the technology, processes, and expertise needed to achieve it.