Concept
The Mandate for Systemic Integrity in Opaque Markets
The Markets in Financial Instruments Directive II (MiFID II) reframes the obligation of best execution from a procedural checklist to a foundational principle of market conduct, particularly within the complex and often opaque domain of Over-the-Counter (OTC) markets. At its core, the directive’s definition of “sufficient steps” represents a significant elevation of regulatory expectation. It moves beyond the previous “reasonable steps” standard of its predecessor, MiFID I. This linguistic shift is not trivial; it codifies a demand for a more rigorous, demonstrable, and data-driven approach to safeguarding client interests.
For institutional participants, this means the entire lifecycle of an OTC transaction, from pre-trade analysis to post-trade reporting, must be embedded within a coherent and defensible operational framework. The regulation compels firms to construct and maintain a system that consistently aims for the optimal outcome for a client, acknowledging that in the fragmented liquidity landscape of OTC products, the “best” result is a multi-faceted concept.
Understanding the “sufficient steps” requirement begins with appreciating the unique structural challenges of OTC markets. Unlike exchange-traded instruments with centralized order books and transparent pricing, OTC products such as bespoke derivatives, certain bonds, and foreign exchange forwards are negotiated bilaterally. This decentralization creates information asymmetry and pricing disparity. Consequently, MiFID II’s mandate is a direct response to this inherent lack of transparency.
Article 27 of the directive stipulates that an investment firm must take “all sufficient steps to obtain the best possible result for its client,” considering a spectrum of execution factors. These factors include not only the headline price but also associated costs, speed, likelihood of execution and settlement, and the size and nature of the order. The directive recognizes that for large or complex OTC trades, a singular focus on price can be misleading. A seemingly advantageous price might conceal significant counterparty risk, settlement delays, or the potential for negative market impact if the order is not handled with discretion.
MiFID II compels firms to prove, on an ongoing basis, that their execution arrangements are not merely adequate, but are systematically designed to achieve the best possible client outcomes in all relevant market conditions.
Deconstructing the Execution Factors
The application of these execution factors is where the theoretical mandate translates into operational reality. MiFID II requires firms to assign relative importance to these factors based on the client’s status (retail or professional), the characteristics of the financial instrument, and the specific instructions provided by the client. For a professional client executing a large, complex interest rate swap, the likelihood of execution and minimizing market impact might far outweigh the raw speed of the transaction. Conversely, for a more standardized OTC product in a liquid market, price and cost may be the dominant considerations.
The “sufficient steps” obligation, therefore, is not a one-size-fits-all prescription. It is a demand for a dynamic and intelligent system of decision-making.
A critical component of this system is the firm’s Order Execution Policy. This document is the foundational blueprint of the firm’s approach. It must clearly articulate, for each class of financial instrument, the venues where the firm will execute orders and the factors that guide the selection process. For OTC products, where formal “venues” may simply be a list of trusted counterparties or liquidity providers, this policy must detail the process for soliciting quotes and assessing their competitiveness.
Article 64 of the MiFID II Delegated Regulation specifically addresses OTC products, requiring firms to check the fairness of the proposed price. This check involves gathering available market data to estimate the product’s value and, where feasible, comparing it to similar or comparable products. This process of price verification is a cornerstone of the “sufficient steps” obligation, transforming best execution from a passive duty to an active, investigative process.
Strategy
Developing a Resilient Execution Policy
A firm’s strategic response to the “sufficient steps” mandate is anchored in its Order Execution Policy. This document transcends a mere compliance formality; it is the strategic charter that governs every facet of the firm’s trading activity. For OTC markets, this policy must be particularly robust, detailing the methodologies for counterparty selection, price discovery, and the balancing of execution factors. The initial step in formulating this strategy is a thorough categorization of the OTC instruments the firm trades.
Instruments should be grouped by characteristics such as liquidity profile, complexity, and data availability. A highly liquid, non-deliverable forward (NDF) will have a different execution protocol than a bespoke, long-dated credit default swap. The policy must articulate these differences clearly.
The strategy for counterparty selection is paramount. The policy should outline the criteria for approving and maintaining a list of execution counterparties. These criteria extend beyond the ability to provide competitive pricing. They should encompass a holistic assessment of the counterparty’s financial stability, settlement efficiency, and operational reliability.
The process for obtaining quotes must also be systematized. For less liquid instruments, this may involve a documented Request for Quote (RFQ) process involving a minimum number of counterparties to ensure competitive tension. The policy must also address the circumstances under which a firm might deviate from its standard process, for example, in cases of extreme market volatility or for exceptionally large orders where information leakage is a primary concern. In such scenarios, dealing with a single counterparty might be justified, but the rationale for this decision must be rigorously documented.
The Interplay of Qualitative and Quantitative Assessment
The “sufficient steps” requirement necessitates a dual-pronged approach to assessing execution quality, blending qualitative judgment with quantitative analysis. While price remains a central element, a purely quantitative focus is insufficient. The strategy must incorporate a framework for evaluating the qualitative aspects of execution that are critical in OTC markets.
- Counterparty Performance ▴ Firms must establish a system for continuously monitoring the performance of their execution counterparties. This goes beyond simple price comparison. It includes tracking metrics like the speed and reliability of quote provision, the rate of settlement failures, and the responsiveness of the counterparty’s trading and support staff. This qualitative data provides essential context to the quantitative results.
- Market Intelligence ▴ An effective strategy involves leveraging market intelligence to inform execution decisions. This includes staying abreast of market trends, understanding the positioning of various market participants, and being aware of factors that could impact liquidity. For many OTC products, this intelligence is gathered through experienced traders and their relationships, a factor that the execution policy should acknowledge and integrate into its framework.
- Transaction Cost Analysis (TCA) ▴ While traditionally associated with equity markets, the principles of TCA are increasingly being applied to OTC instruments. A sophisticated strategy will involve developing or adopting TCA models appropriate for the specific characteristics of OTC products. This analysis should measure execution costs against relevant benchmarks, which for OTC products might include the firm’s own valuation models, data from third-party providers, or the prices of comparable instruments.
The following table illustrates a simplified framework for balancing execution factors for different types of OTC derivatives, a core component of a firm’s execution strategy.
| Instrument Type | Primary Factor | Secondary Factor | Tertiary Factor | Rationale |
|---|---|---|---|---|
| Standard Interest Rate Swap (Vanilla IRS) | Price | Costs | Speed | High liquidity and standardization make price the dominant factor. Low transaction costs are also key. |
| Exotic FX Option | Likelihood of Execution | Price | Counterparty Strength | Complexity and illiquidity mean finding a willing and capable counterparty is the primary challenge. Price is important but secondary to securing the trade. |
| Large Corporate Bond Block | Minimizing Market Impact | Price | Likelihood of Settlement | The size of the order necessitates a focus on avoiding adverse price movements. Ensuring smooth settlement is also critical. |
| Structured Credit Product | Price Fairness Verification | Counterparty Strength | Likelihood of Execution | Bespoke nature requires intensive pre-trade work to verify the fairness of the price, often using internal models. The long-term nature of the product makes counterparty risk a major concern. |
Monitoring and Review the Feedback Loop
A static strategy is a failing strategy under MiFID II. The directive mandates that firms must “monitor the effectiveness of their order execution arrangements and execution policy on a regular basis.” This creates a requirement for a continuous feedback loop where the results of execution monitoring are used to identify and correct any deficiencies in the firm’s strategy. This review process should be conducted at least annually, or whenever a material change occurs that could affect the firm’s ability to achieve the best possible result for its clients. A material change could be a shift in market liquidity, the emergence of a new execution venue or counterparty, or a change in the firm’s own trading patterns.
The results of this review must be documented, and any subsequent changes to the execution policy must be communicated to clients. This iterative process of monitoring, reviewing, and refining is the engine that drives a compliant and effective best execution strategy. It ensures that the firm’s approach remains robust and aligned with the evolving dynamics of the OTC markets.
Execution
Operationalizing the Price Fairness Assessment
The execution of the “sufficient steps” obligation in OTC markets hinges on a firm’s ability to operationalize the concept of “price fairness.” As mandated by Article 64 of the MiFID II Delegated Regulation, this is an active, pre-trade process, not a passive acceptance of a counterparty’s quote. The first step in executing this is the systematic gathering of relevant market data. This data serves as the foundation for the firm’s internal valuation of the OTC instrument. The sources of this data can be diverse and must be appropriate for the instrument in question.
- Data Aggregation ▴ For more liquid OTC instruments, such as standard FX forwards or interest rate swaps, firms should utilize data feeds from multiple sources. This could include contributions from various banks, inter-dealer broker screens, or data from trading venues like Swap Execution Facilities (SEFs) or Organised Trading Facilities (OTFs). The goal is to create a composite view of the market that can be used to generate a reliable mid-price.
- Comparable Instruments ▴ For less liquid or more bespoke products, the process becomes more inferential. Firms must execute a process of valuation based on “similar or comparable products.” For example, the price of an illiquid corporate bond might be benchmarked against the prices of more frequently traded bonds from the same issuer or from issuers in the same sector with a similar credit rating. The pricing of a complex derivative might be broken down into its more vanilla components, each of which can be priced with greater confidence.
- Internal Modeling ▴ The firm’s own quantitative models play a central role. These models, which should be independently validated and regularly reviewed, are used to generate an expected “fair value” for the instrument before any quotes are solicited. This internal valuation serves as the primary benchmark against which incoming quotes are judged. The inputs to these models (e.g. yield curves, volatility surfaces, credit spreads) must be sourced from reliable and up-to-date market data.
When a quote is received from a counterparty, it is not simply accepted or rejected. It is compared against this pre-trade benchmark. Any significant deviation between the counterparty’s quote and the firm’s internal valuation must be investigated and justified.
This justification must be documented and retained, forming a crucial part of the audit trail that demonstrates that sufficient steps were taken. This process transforms every OTC trade into a miniature research project, demanding a robust infrastructure of data, analytics, and disciplined procedure.
The operational execution of MiFID II’s best execution rules requires a shift from relationship-based trading to an evidence-based framework where every decision is justifiable through data.
The Infrastructure of Monitoring and Reporting
Demonstrating compliance with the “sufficient steps” obligation is impossible without a robust infrastructure for monitoring and reporting. This infrastructure has two main components ▴ the internal monitoring of execution quality and the external reporting requirements under Regulatory Technical Standards (RTS) 27 and 28. Internally, firms must capture a wide range of data for every order and execution.
This data must be detailed enough to allow for a comprehensive post-trade Transaction Cost Analysis (TCA). The following table provides an example of the kind of data that a firm would need to capture to effectively monitor the execution quality of its OTC trades.
| Data Field | Description | Example (for an IRS trade) | Purpose |
|---|---|---|---|
| Order ID | Unique identifier for the client order. | ORD-20250807-001 | Audit trail and linkage. |
| Instrument Identifier | Unique code for the instrument (e.g. ISIN). | DE000A1G6L27 | Precise identification of the traded product. |
| Pre-Trade Benchmark | The firm’s internal fair value estimate at the time of the RFQ. | 1.525% | Primary measure for price fairness assessment. |
| RFQ Timestamp | Time the Request for Quote was sent to counterparties. | 2025-08-07 14:30:15 UTC | Measures counterparty responsiveness. |
| Counterparty Quotes | A record of all quotes received, including price and timestamp. | CPTY_A ▴ 1.528% (14:30:25), CPTY_B ▴ 1.527% (14:30:28) | Evidence of competitive process; TCA input. |
| Execution Timestamp | Time the trade was executed. | 2025-08-07 14:30:35 UTC | Measures execution speed and latency. |
| Executed Price | The final price at which the trade was executed. | 1.527% | Calculation of slippage against benchmark. |
| Execution Slippage | Difference between the executed price and the pre-trade benchmark. | +0.2 bps | Core metric of execution quality. |
| Rationale for Selection | A documented reason for choosing the executing counterparty. | “CPTY_B selected for best price.” or “CPTY_A selected due to size capacity despite slightly worse price.” | Qualitative justification for the trading decision. |
This internal data then feeds the external reporting obligations. While RTS 27 reports on execution quality are provided by execution venues, RTS 28 reports are the responsibility of the investment firm. Annually, firms must publish a report detailing their top five execution venues (or counterparties in the case of OTC trades) for each class of financial instrument. They must also provide a summary of the analysis and conclusions drawn from their detailed monitoring of the execution quality obtained.
This public disclosure is the ultimate expression of the “sufficient steps” principle. It forces firms to stand behind their execution strategies and provides clients and regulators with the data needed to assess their performance. The execution of this reporting requires a significant investment in data management and analytics technology, capable of aggregating vast amounts of trade data and presenting it in the prescribed format.
References
- Hogan Lovells. “Achieving best execution under MiFID II.” 31 August 2017.
- KPMG. “Best Execution Under MiFID II.” 2017.
- Millennium Global. “Best Execution Policy.” 2018.
- European Securities and Markets Authority. “Final Report on the Technical Standards specifying the criteria for establishing and assessing the effecti.” ESMA35-335435667-6253, 10 April 2025.
- Aberdeen Asset Management. “Global Order Execution Policy.” 2018.
- Financial Conduct Authority. “Markets in Financial Instruments Directive II Implementation ▴ Policy Statement II.” PS17/14, July 2017.
- Lehalle, Charles-Albert, and Sophie Moinas, editors. Market Microstructure ▴ Confronting Many Viewpoints. Wiley, 2016.
- Harris, Larry. Trading and Exchanges ▴ Market Microstructure for Practitioners. Oxford University Press, 2003.
Reflection
From Mandated Procedure to Operational Intelligence
The intricate requirements surrounding the “sufficient steps” for best execution in OTC markets represent a fundamental shift in regulatory philosophy. The framework moves the industry from a compliance-oriented mindset, focused on satisfying a static list of obligations, toward a dynamic system of continuous improvement and demonstrable integrity. The true challenge lies not in adhering to each individual rule, but in engineering a holistic operational environment where the principles of best execution are an emergent property of the system itself. This involves the seamless integration of quantitative analysis, qualitative judgment, technological infrastructure, and rigorous governance.
Viewing the mandate through this lens reveals its deeper purpose. It is a catalyst for firms to develop a more profound understanding of the markets in which they operate and the true nature of the costs and risks embedded in their execution processes. The data generated through rigorous monitoring and reporting becomes more than just a regulatory submission; it transforms into a valuable source of business intelligence. This intelligence can be used to refine trading strategies, optimize counterparty relationships, and ultimately, deliver superior results for clients.
The firms that will thrive in this environment are those that see the “sufficient steps” not as a burden, but as a blueprint for building a more sophisticated, resilient, and competitive execution capability. The ultimate goal is a state where the system itself, through its design and constant self-assessment, ensures that the client’s best interest is not just a consideration, but the central, guiding output of the entire operational process.
Glossary
Sufficient Steps
Best Execution
Otc Products
Otc Markets
Mifid Ii
Execution Factors
Order Execution Policy
Counterparty Selection
Execution Policy
Execution Quality
Their Execution
Transaction Cost Analysis
Order Execution
Price Fairness
Regulatory Technical Standards
Transaction Cost
Rts 27
