How Does Mifid Ii Define Best Execution for Illiquid Assets Traded via Rfq?

Concept

The Markets in Financial Instruments Directive II (MiFID II) establishes a comprehensive framework for best execution, requiring firms to secure the most favorable terms for their clients. For illiquid assets traded via a Request for Quote (RFQ) protocol, this mandate transforms into a nuanced, evidence-based process. The core obligation is to take “all sufficient steps” to achieve the best possible result, a significant shift from the previous “all reasonable steps” standard.

This change underscores a move towards a more demonstrable and data-driven compliance culture. The directive recognizes that for instruments with limited price transparency and sporadic trading interest, the definition of “best” extends beyond a singular focus on price.

Within this system, the RFQ mechanism serves as a primary tool for price discovery in markets lacking a continuous, liquid order book. For an illiquid corporate bond or a bespoke over-the-counter (OTC) derivative, a centralized lit market price is often unavailable. Consequently, a firm must construct a view of the market by soliciting quotes from multiple liquidity providers.

MiFID II scrutinizes this process, compelling firms to justify their choice of counterparties and the ultimate execution decision based on a range of predefined execution factors. The regulation effectively codifies the institutional practice of “shopping around” for a price, demanding a structured, auditable, and repeatable process where one previously might have been informal.

The Execution Factors in an Illiquid Context

MiFID II specifies a set of execution factors that firms must consider. These are price, costs, speed, likelihood of execution and settlement, size, and the nature of the order. The directive grants firms the flexibility to determine the relative importance of these factors based on the client’s objectives, the instrument’s characteristics, and the prevailing market conditions. For illiquid assets, this hierarchy of factors is fundamentally different from that for liquid securities.

The likelihood of execution often becomes the paramount consideration. Sourcing any competitive bid or offer for a large block of an obscure asset can be the primary challenge. In such cases, the ability to complete the trade at a firm price outweighs the benefit of a marginal price improvement or the speed of the transaction. Price remains a critical component, but it is assessed within the context of available liquidity.

The “best” price is the most advantageous one that can be reliably executed for the desired size without causing adverse market impact. Speed of execution, a key metric in liquid electronic markets, is typically relegated to a lower priority, as the process of sourcing quotes from multiple dealers inherently takes time.

The regulation reframes best execution for illiquid assets as a disciplined search for a defensible price within a fragmented liquidity landscape.

This framework necessitates a robust internal policy that clearly outlines how the firm will weigh these factors for different types of illiquid instruments. The policy must be detailed enough to guide traders and transparent enough to be explained and justified to both clients and regulators. The firm must be able to demonstrate, through data and documentation, why its chosen execution strategy was the most appropriate course of action to achieve a favorable outcome for the client.

Strategy

A compliant strategy for executing illiquid assets via RFQ under MiFID II is built upon a foundation of process and evidence. It moves the act of trading from a discretionary art to a structured science, where every decision is justifiable and logged. The primary strategic objective is to construct a framework that consistently delivers and demonstrates best execution across a portfolio of trades, rather than on a single-transaction basis. This involves developing a sophisticated approach to counterparty selection, quote analysis, and data management.

The firm’s Order Execution Policy is the central strategic document. This policy must explicitly detail the procedures for handling illiquid instruments and RFQ workflows. It should specify the criteria for selecting counterparties to include in an RFQ, the typical number of dealers to poll for different types of assets and trade sizes, and the methodology for evaluating the quotes received.

For instance, the policy might state that for an illiquid corporate bond trade below a certain notional value, a minimum of three quotes from a pre-vetted list of dealers is required. For a larger, more complex derivative, the requirement might increase to five or more quotes.

Counterparty Selection and Quote Evaluation

A key strategic element is the systematic management of liquidity providers. Firms must maintain and regularly review their list of execution venues and counterparties to ensure they provide consistent and competitive pricing for specific asset classes. This process involves analyzing historical execution data to identify which dealers are most responsive and provide the tightest spreads for particular types of illiquid instruments. The strategy is to cultivate a diverse set of liquidity relationships to avoid over-reliance on a single provider and to ensure competitive tension in the quoting process.

When quotes are received, the evaluation strategy extends beyond simply picking the best price. The firm must consider the “quality” of the liquidity. This includes assessing the likelihood of the dealer honoring the quoted price, the potential for information leakage if the inquiry is shopped around too widely, and the settlement risk associated with each counterparty. A slightly less aggressive price from a highly reliable counterparty may represent a better overall result for the client than a more attractive price from a less dependable one.

The following table illustrates the strategic shift in prioritizing execution factors when moving from liquid to illiquid assets:

Demonstrating Compliance through Data

The ultimate strategic goal is to create a defensible audit trail. MiFID II compliance hinges on the ability to prove that “all sufficient steps” were taken. This requires a technology infrastructure capable of capturing every stage of the RFQ workflow, including:

• Timestamps ▴ Precise timing of when a quote was requested, when each response was received, and when the order was executed.
• All Quotes ▴ A record of every price received from all polled dealers, not just the winning one.
• Execution Rationale ▴ If the best-priced quote was not chosen, a documented reason for this decision (e.g. concerns about settlement risk or the dealer’s ability to handle the size).

This data feeds into both ex-post analysis, like Transaction Cost Analysis (TCA), and regulatory reporting, such as the annual RTS 28 reports, which require firms to disclose their top five execution venues for each class of financial instrument. A sound strategy ensures that this data collection is an integrated part of the trading process, not an administrative afterthought.

Execution

The execution of an illiquid asset trade via RFQ under MiFID II is a highly structured process, governed by the firm’s internal policies and enabled by its technological infrastructure. It transforms a bilateral negotiation into a formalized, multi-party price discovery event that must be meticulously documented. The focus of execution is on the operational steps required to ensure compliance and achieve a favorable client outcome in a market defined by opacity.

The Operational Playbook for an Illiquid RFQ

A trader executing an order for an illiquid instrument follows a precise operational sequence. This playbook ensures that the “sufficient steps” requirement is met consistently across the trading desk.

1. Order Analysis (Pre-Trade) ▴ Upon receiving a client order, the trader first assesses its characteristics. Key questions include ▴ What is the true liquidity profile of this specific instrument (e.g. CUSIP, ISIN)? What is the market appetite for this size? The trader consults pre-trade analytics and historical data to inform the execution strategy.
2. Counterparty Selection ▴ Based on the pre-trade analysis and the firm’s execution policy, the trader selects a list of dealers to include in the RFQ. This selection is documented and must be justifiable, often based on which counterparties have historically provided the best liquidity and pricing for similar instruments.
3. RFQ Dissemination ▴ The trader uses an execution management system (EMS) to send the RFQ simultaneously to the selected dealers. The system logs the exact time of the request and which dealers received it. Discretion is key to avoid information leakage that could lead to adverse market impact.
4. Quote Aggregation and Evaluation ▴ As quotes arrive, the EMS aggregates them in a centralized blotter. Each quote is timestamped. The trader evaluates the responses based on the prioritized execution factors ▴ typically likelihood of execution, price, and size capacity.
5. Execution and Rationale Capture ▴ The trader executes the order with the chosen counterparty. The system captures the execution price and time. Crucially, if the selected quote was not the best price, the system must prompt the trader to provide a clear, concise justification for the decision.
6. Post-Trade Data Logging ▴ All data related to the RFQ process ▴ every quote requested and received, all timestamps, and the execution details ▴ is automatically logged and stored for a minimum of five years, as required by the directive. This data forms the basis for all subsequent analysis and reporting.

Quantitative Analysis and Reporting

The data captured during execution is not merely for storage; it is actively used to monitor and prove the quality of execution over time. Transaction Cost Analysis (TCA) for illiquid assets is more nuanced than for equities. It focuses on measuring the quality of the execution against the available quotes and the firm’s historical performance.

For illiquid instruments, the evidence of best execution lies in the quality of the process and the data it generates.

The following table provides a simplified example of the data fields required for post-trade analysis and RTS 28 reporting for illiquid fixed income RFQs. This data allows the firm to quantitatively assess its execution quality and demonstrate compliance.

This systematic approach to execution ensures that the firm is not only striving to achieve the best result for each individual client order but is also building a comprehensive body of evidence. This evidence demonstrates a consistent, disciplined, and compliant process that can withstand the scrutiny of both clients and regulators, turning a regulatory burden into a showcase of operational excellence.

Reflection

The integration of MiFID II’s principles into the fabric of illiquid asset trading represents a fundamental shift in operational philosophy. The directive compels firms to construct a verifiable system of record for what was once a more opaque process. This system, built on data and structured procedure, becomes the definitive measure of a firm’s duty to its clients. The challenge lies in viewing this framework as an asset rather than a constraint.

How does the data captured for compliance today inform the trading strategy of tomorrow? The detailed records of dealer responsiveness, quote competitiveness, and settlement reliability are more than just an audit trail; they are a proprietary dataset. This information holds the potential to refine counterparty selection, optimize RFQ strategies, and ultimately provide a quantifiable edge in sourcing liquidity. The regulatory mandate for transparency can, with the right analytical approach, become the blueprint for superior execution performance.