How Does MiFID II Define Best Execution for Illiquid Derivatives?

Concept

When an institutional desk is tasked with executing a derivative that has no screen price, no central limit order book, and a very limited number of potential counterparties, the traditional model of execution quality breaks down. The system requires a different logic. MiFID II, in its application to illiquid derivatives, provides exactly that. It establishes a procedural and evidence-based framework designed to govern decision-making in opaque market structures.

The regulation defines best execution for these instruments as a mandate for investment firms to construct and diligently follow a robust, repeatable, and auditable process aimed at achieving the optimal outcome for the client. This process is documented within the firm’s order execution policy.

The core of the directive compels firms to take “all sufficient steps” to secure the best possible result for their clients. For illiquid over-the-counter (OTC) products, this transcends a simple search for the best price. The regulation acknowledges that in such markets, factors like speed, likelihood of execution, settlement finality, and counterparty risk are integral components of the overall execution quality. The “best possible result” is a holistic concept, a weighted aggregation of these execution factors, where the weighting itself is dependent on the client’s specific objectives, the nature of the order, and the prevailing market conditions.

This creates a flexible yet rigorous standard. The firm must demonstrate not that it achieved a theoretical perfect price, but that it systematically and intelligently navigated the available liquidity to produce an outcome that was demonstrably fair and in the client’s best interest under the circumstances.

What Is the Core Obligation for OTC Products?

The central pillar of best execution for illiquid instruments is the requirement to assess the fairness of the price. Since a public, observable price is absent, the firm must construct a proxy for fairness. This is achieved by gathering relevant market data, which can include inputs to pricing models like yield curves, volatility surfaces, and correlation matrices. The firm is then expected, where possible, to compare the proposed price against similar or comparable products for which more data might be available.

For instance, a bespoke interest rate swap might be benchmarked against a more standard, liquid swap with similar characteristics. This process of “marking to model” or “marking to matrix” is a foundational element. It shifts the burden of proof onto the executing firm, requiring it to build an internal, data-driven justification for the transaction price. The quality of this internal valuation process becomes a direct proxy for the quality of the execution itself.

The directive transforms the abstract idea of fairness into a concrete, evidence-based valuation and comparison process.

This procedural obligation extends to the entire lifecycle of the trade. It begins with the pre-trade analysis, where the firm must identify potential execution venues and counterparties. For illiquid derivatives, “venues” often means a curated list of dealers or liquidity providers. The firm’s selection of these counterparties is itself subject to due diligence.

The execution method, most commonly a Request for Quote (RFQ) process, must be structured to elicit competitive tension. Post-trade, the firm must document the results, including the quotes received and the justification for the chosen counterparty, creating an audit trail that substantiates the execution logic.

A System of Factors

MiFID II enumerates a set of execution factors that must be considered. While price and costs are paramount, particularly for retail clients, the framework allows for a more sophisticated calculus for professional clients and complex instruments. The factors include:

• Price The price at which the derivative is executed. For illiquid instruments, this is the price that must be validated for fairness through internal modeling and comparison.
• Costs All costs associated with the transaction, including the firm’s own commission, clearing fees, and settlement charges. The directive requires transparency in how these costs are structured.
• Speed The velocity of execution. In volatile markets, the ability to execute quickly can be more valuable than achieving a marginal price improvement.
• Likelihood of Execution and Settlement The certainty that the trade will be completed and settled successfully. This factor directly incorporates counterparty risk assessment. A slightly better price from a less reliable counterparty may not constitute the best overall result.
• Size and Nature of the Order A large or complex order may require sourcing liquidity from multiple counterparties or executing in stages to minimize market impact. The strategy must be tailored to the specific characteristics of the order.

The regulation empowers firms to determine the relative importance of these factors based on the client’s profile, the order’s characteristics, the instrument’s properties, and the potential execution venues. For a highly structured, long-dated derivative, the likelihood of settlement and the precision of the pricing model might outweigh the raw speed of execution. For a large block trade in a thinly traded instrument, minimizing information leakage and market impact could be the dominant consideration. This dynamic weighting is what allows the principle of best execution to be applied meaningfully to the heterogeneous world of illiquid derivatives.

Strategy

Developing a MiFID II-compliant best execution strategy for illiquid derivatives is an exercise in system design. It involves creating a structured, repeatable framework that can operate effectively in markets defined by opacity and decentralization. The strategy must address three core domains ▴ pre-trade intelligence, execution protocol design, and post-trade validation. The objective is to construct a defensible process that consistently delivers the best possible outcome for the client, as defined by the multi-faceted criteria of the regulation.

The initial phase involves a fundamental shift in perspective from passive price-taking to active price discovery. For liquid, exchange-traded instruments, the strategy often centers on minimizing slippage against a visible benchmark, like the arrival price or VWAP. For illiquid derivatives, the benchmark itself must be constructed. The strategy, therefore, begins with the systematic gathering of market data to inform internal pricing models.

This is the foundation of the “fairness” assessment. A firm’s strategy must detail the sources of this data ▴ be it from data vendors, broker feeds, or internal trade histories ▴ and the governance around its use. The quality of this pre-trade intelligence directly dictates the firm’s ability to negotiate effectively and to later evidence the quality of its execution.

Framework for Counterparty and Venue Selection

In the OTC derivatives market, the concepts of “venue” and “counterparty” are deeply intertwined. A strategy must outline a clear methodology for selecting and managing relationships with liquidity providers. This is not a static list; it is a dynamic process of evaluation based on a range of qualitative and quantitative factors. A robust strategy will incorporate a formal counterparty scoring system.

This scoring system should be codified in the firm’s execution policy and applied consistently. It transforms the subjective process of “shopping around” for a quote into a structured, data-driven decision. The table below illustrates a potential framework for such a scoring system.

By employing such a framework, a firm can justify its choice of counterparties for any given RFQ. It can demonstrate that its selection process is designed to optimize for a range of factors beyond just the headline price, directly addressing the requirements of MiFID II. This systematic approach is particularly critical when a firm places significant reliance on a small number of liquidity providers.

Designing the Execution Protocol

The Request for Quote (RFQ) protocol is the dominant execution method for illiquid derivatives. However, all RFQ processes are not created equal. A sophisticated best execution strategy will define the specific mechanics of the RFQ process to maximize its effectiveness. This includes specifying the number of counterparties to include in an inquiry, the time allowed for responses, and the protocol for handling information leakage.

A well-designed RFQ process acts as a controlled mechanism for price discovery in an otherwise unstructured market.

The strategy should differentiate the RFQ approach based on the characteristics of the order. For example:

• Standard Illiquid Instruments For derivatives that are non-standard but have some comparable products, an RFQ to a minimum of three to five pre-vetted counterparties might be the standard procedure. This creates sufficient competitive tension to ensure a fair price.
• Highly Bespoke or Large-Scale Instruments For exceptionally unique or large trades, the strategy might involve a more discreet, two-stage process. The first stage could be a non-binding “price check” with a wider group of counterparties to gauge the market. The second stage would be a formal RFQ with a smaller, select group of providers deemed most capable of handling the specific risk profile of the trade. This minimizes information leakage that could lead to adverse market movements.

The strategy must also account for situations where an RFQ is not feasible or optimal. For instance, if a client provides a specific instruction to trade with a particular counterparty, the best execution obligation is considered met for that aspect of the trade. The firm’s strategy must detail how such instructions are recorded and processed to ensure a clear audit trail.

How Does Post Trade Analysis Drive Strategy?

The final component of the strategy is a closed-loop feedback system based on post-trade analysis. This is where Transaction Cost Analysis (TCA) for illiquid instruments comes into play. Unlike TCA for equities, which measures slippage against a market price, TCA for illiquid derivatives measures the execution quality against the firm’s own pre-trade benchmarks. The analysis seeks to answer several key questions:

1. Price Fairness Validation Was the executed price consistent with the pre-trade internal valuation, and how did it compare to the other quotes received?
2. Counterparty Performance Which counterparties consistently provided the tightest spreads and the most reliable settlement? This data feeds back into the counterparty scoring matrix.
3. Process Efficiency Was the execution process timely? Were there any operational bottlenecks?

The insights gleaned from this analysis are then used to refine the strategy. It allows the firm to identify underperforming counterparties, improve its internal pricing models, and optimize its RFQ protocols. This continuous cycle of execution, analysis, and refinement is the hallmark of a dynamic and effective best execution strategy under MiFID II. It demonstrates that the firm is not just following a static policy, but is actively taking steps to improve the quality of its execution on an ongoing basis.

Execution

The execution of MiFID II’s best execution requirements for illiquid derivatives is a matter of operationalizing a complex set of principles. It requires the integration of policy, technology, and quantitative analysis into a seamless workflow. This is where the architectural vision of the regulation is translated into the granular, day-to-day functions of the trading desk. The process must be robust enough to withstand regulatory scrutiny and sophisticated enough to handle the unique challenges of non-vanilla financial instruments.

At its core, the execution framework is an evidence-gathering machine. Every step, from the initial client order to the final settlement, must be logged and justified. The framework must demonstrate that the firm has taken “all sufficient steps” to achieve the best possible result, and this demonstration must be rooted in verifiable data. The following sub-chapters provide a detailed playbook for constructing such a framework, covering the operational procedures, the quantitative models, a practical case study, and the underlying technological architecture.

The Operational Playbook

This playbook outlines the end-to-end operational process for ensuring and evidencing best execution for an illiquid derivative trade. It is a sequence of mandatory checks and procedures that form a complete audit trail.

1. Order Inception and Classification The process begins when a client order is received. The first step is to classify the instrument. The system must identify it as an illiquid derivative, which triggers this specific best execution workflow. Key data points to capture at this stage include the client’s identity, their categorization (retail or professional), the specific instrument details, and any special instructions provided by the client.
2. Pre-Trade Price Fairness Assessment Before approaching the market, the trading desk must establish a pre-trade benchmark price. This is the “fairness” check mandated by the regulation. This involves:
   • Data Gathering Sourcing all relevant inputs for a pricing model. For an interest rate swap, this would include the relevant yield curve, basis spreads, and volatility data.
   • Model-Based Valuation Using a validated internal pricing model to generate an expected price for the derivative. The model itself should be subject to periodic review and validation by a separate risk or model validation function.
   • Comparable Product Analysis Where possible, identifying similar or comparable instruments that have more observable pricing data and using them to cross-check the model-based valuation. All findings, including the benchmark price and the data used to derive it, must be logged in the order management system.
3. Counterparty Selection and RFQ Initiation Using the pre-defined Counterparty Scoring Matrix (as detailed in the Strategy section), the trader selects a list of counterparties to include in the RFQ. The number of counterparties should be appropriate for the instrument’s liquidity profile, as defined in the firm’s execution policy. The RFQ is then initiated through an electronic platform or other recorded communication channel. The RFQ must specify a reasonable deadline for responses.
4. Quote Analysis and Execution Decision As quotes are received, they are logged and compared against both each other and the pre-trade benchmark price. The trader’s decision is not based solely on the best price. The decision must be made in accordance with the holistic “best possible result” principle. For example, a trader might choose a quote that is slightly off the best price if it comes from a counterparty with a significantly higher credit rating and a better settlement track record. The justification for this decision must be explicitly recorded. This record should reference the firm’s counterparty scoring data.
5. Post-Trade Documentation and Monitoring Once the trade is executed, a comprehensive record is compiled. This record includes the initial order, the pre-trade price assessment, the list of counterparties in the RFQ, all quotes received, the final execution price and time, and the explicit justification for the execution decision. This forms the core evidence for best execution. On a periodic basis (e.g. quarterly), this data is aggregated and analyzed as part of the firm’s TCA process to monitor the quality of its execution and the performance of its counterparties.

Quantitative Modeling and Data Analysis

Evidencing best execution in illiquid markets is a quantitative exercise. It relies on models to establish fairness and data analysis to prove diligence. The following tables represent the type of data that a firm must maintain and analyze to meet its obligations.

The first table details the pre-trade valuation process for a hypothetical bespoke 7-year Euro interest rate swap. It demonstrates the construction of a fair value benchmark before approaching the market.

The next table documents the RFQ process itself. It provides a clear, auditable record of the competitive pricing sought by the firm and the rationale for its final decision. This table is the primary evidence that the firm took sufficient steps to achieve the best possible result.

Predictive Scenario Analysis

Consider a portfolio manager at an asset management firm who needs to hedge the interest rate risk on a portfolio of European corporate bonds. The desired instrument is a €100 million, 12-year inflation-linked swap, where the firm pays a fixed rate and receives a floating rate linked to the Eurozone Harmonised Index of Consumer Prices (HICP). This is a highly illiquid and bespoke derivative.

The firm’s head trader, operating under a MiFID II compliant framework, initiates the execution process. The first action is to trigger the “illiquid derivative” workflow in their Execution Management System (EMS). The system immediately prompts the trader to perform a pre-trade fairness assessment. The quant team is tasked with this.

They gather HICP inflation projections, the Euro sovereign yield curve, and data from the more liquid nominal interest rate swap market. They use an internal model to calculate a fair value fixed rate for the swap, arriving at a benchmark of 1.75%, with a tolerance of +/- 3 basis points.

Next, the trader consults the firm’s counterparty management system. The system provides a ranked list of approved dealers for this type of instrument, based on the firm’s scoring matrix. For a trade of this size and tenor, the execution policy mandates an RFQ to at least four counterparties with a minimum credit rating of A+. The trader selects five dealers ▴ two large international banks, two regional specialists in inflation products, and one smaller, highly-rated dealer known for aggressive pricing.

The RFQ is sent electronically via the EMS, ensuring all communications are logged. The request specifies the full details of the swap and gives the dealers 30 minutes to respond. As the quotes arrive, they populate the EMS dashboard in real-time. The first quote is 1.78%.

The second is 1.77%. The third, from one of the specialists, is 1.765%. The fourth, from the aggressive smaller dealer, is 1.755%. The final quote is 1.775%.

The best price is 1.755%, just 0.5 basis points above the pre-trade benchmark. However, the trader’s dashboard shows that this dealer has a slightly lower settlement reliability score than the others. The second-best price, 1.765%, comes from a large international bank with the highest possible credit rating and a flawless settlement record. The trader must now make a judgment call.

The 1 basis point difference in price amounts to €10,000 per year over the life of the swap. The trader weighs this against the heightened settlement risk and potential future operational headaches of dealing with the lower-ranked counterparty. Citing the firm’s execution policy, which prioritizes settlement finality for long-dated, complex trades, the trader decides to execute the trade at 1.765% with the more reliable counterparty. They type a justification into the EMS, which is timestamped and saved with the trade record ▴ “Selected counterparty due to superior credit rating and settlement score, justifying the 1bp price differential in line with client best interest for this long-term hedge.” The entire process, from order inception to execution, is now a fully documented, auditable file that demonstrates compliance with MiFID II.

System Integration and Technological Architecture

A robust technological architecture is the sine qua non of complying with MiFID II for illiquid derivatives. It is the system that enables, enforces, and evidences the operational playbook. The architecture must connect disparate functions into a cohesive whole.

The central component is a sophisticated Order and Execution Management System (OMS/EMS). This system must have specific modules designed for OTC instruments. Key capabilities include:

• Instrument Classification Engine The ability to automatically identify an instrument as illiquid based on its properties, triggering the appropriate compliance workflow.
• Integrated Pricing Tools API connections to internal quant libraries and external data vendors (e.g. Bloomberg, Refinitiv) to allow for seamless pre-trade valuation directly within the trading workflow.
• RFQ Management Module A dedicated function for creating, sending, and managing RFQs to multiple counterparties. It must support various communication protocols (e.g. FIX, proprietary APIs) and log all interactions, including timestamps of quotes.
• Compliance Logic Engine The ability to encode the firm’s execution policy directly into the system. For example, the system could prevent a trader from executing a trade without first recording a pre-trade benchmark or providing a justification for selecting a non-best-price quote.

This OMS/EMS does not operate in a vacuum. It must be integrated with other critical systems:

1. Data Warehouse All trade and order data from the OMS/EMS must flow into a central data warehouse. This is where the data is stored for regulatory reporting (such as the RTS 28 reports on top five venues) and for internal TCA.
2. Counterparty Management System A centralized database containing all due diligence information and performance scores for each liquidity provider. The OMS/EMS should query this system in real-time to inform the trader’s selection process.
3. Settlement and Clearing Systems Post-execution, the trade details must be passed seamlessly to the back-office systems for confirmation, settlement, and clearing, ensuring data integrity throughout the trade lifecycle.

The technological architecture provides the rigid skeleton upon which the flexible, judgment-based decisions of the trader can be built. It ensures that every decision is made within a controlled, monitored, and auditable environment, which is the ultimate execution of the MiFID II directive.

Reflection

The framework established by MiFID II for illiquid derivatives prompts a fundamental question for any investment firm ▴ is your operational architecture a genuine asset, or is it merely a compliance utility? The regulation provides the schematic for a system of evidence-based decision-making. The true strategic advantage, however, is realized when a firm builds upon that schematic, transforming the mandated processes into a source of competitive intelligence. The data gathered for compliance can, and should, become the fuel for a more sophisticated understanding of market dynamics and counterparty behavior.

Consider the repository of quote data collected through the RFQ process. Viewed through a compliance lens, it is an audit trail. Viewed through a strategic lens, it is a proprietary dataset revealing the pricing appetite and axes of your counterparties.

Analyzing this data over time can yield powerful insights, allowing for more predictive and effective sourcing of liquidity. The mandated procedures, therefore, present an opportunity to construct a superior operational system ▴ one that not only satisfies the regulator but also systematically enhances execution quality and informs the firm’s overall market strategy.