How Does MiFID II Specifically Define Best Execution for OTC Products?

Concept

The Markets in Financial Instruments Directive II (MiFID II) imposes a rigorous and evidence-based obligation for achieving best execution, extending its reach deep into the complex world of over-the-counter (OTC) products. For these instruments, which lack the centralized pricing mechanisms of exchange-traded products, the directive moves the goalposts for investment firms. The framework demands a demonstrable and systematic process to ensure the “best possible result” for clients, a concept that encompasses much more than just the headline price. This requirement applies across all financial instruments, compelling firms to adapt their execution strategies to the unique structures of each product class.

At its core, the directive’s application to OTC products is about ensuring fairness and transparency in inherently opaque markets. When a firm executes an order or decides to deal in OTC instruments, including highly customized or “bespoke” products, it must verify the fairness of the price offered to the client. This verification is an active, pre-trade process. It requires the firm to gather relevant market data to build its own price estimation for the product.

Where feasible, this internal valuation must be cross-referenced by comparing it with similar or comparable products available in the market. This process transforms best execution from a passive compliance exercise into an active, data-driven defense of the client’s interests.

MiFID II mandates that firms executing OTC trades must actively check the fairness of the client’s price by gathering market data and comparing it to comparable products.

The regulation acknowledges that for many sophisticated OTC products, price is just one component of a larger equation. The “best possible result” is determined by a holistic assessment of various execution factors. While total consideration, which combines the price of the instrument and all associated costs, remains the paramount factor for retail clients, the calculus for professional clients is more complex.

For them, factors like the speed of execution, the likelihood of a successful trade, the size and nature of the order, and the potential for market impact can assume greater importance. The directive requires firms to weigh these factors intelligently, justifying their execution strategy based on the specific characteristics of the client, the order, and the instrument itself.

Strategy

The Execution Policy Framework

A successful strategy for MiFID II compliance in the OTC space hinges on a meticulously crafted and dynamic Order Execution Policy. This document is the central pillar of a firm’s approach, articulating with clarity and sufficient detail how it will achieve the best possible result for its clients. The policy must specify, for each class of financial instrument, the execution venues the firm relies on and, critically, the relative importance assigned to the different execution factors that guide the choice of venue. This policy is a public-facing commitment, explaining to clients in an easily understandable manner the mechanics of how their orders will be handled.

The selection of execution venues for OTC products is a key strategic decision. These venues can include regulated markets, multilateral trading facilities (MTFs), organised trading facilities (OTFs), systematic internalisers (SIs), market makers, or other liquidity providers. A firm’s policy must list the venues where it places “significant reliance” to consistently achieve the best outcomes.

This selection process must be evidence-based, supported by ongoing monitoring of the execution quality delivered by each venue. Firms are required to review their execution policies and arrangements at least annually, or whenever a material change occurs that could affect their ability to deliver best execution.

Weighing the Execution Factors

MiFID II codifies a set of execution factors that firms must consider when executing client orders. The strategic challenge lies in assigning the appropriate weight to each factor based on the context of the trade. The primary factors include:

• Price ▴ The price at which the transaction is executed.
• Costs ▴ All expenses incurred by the client that are directly related to the execution of the order, including venue fees, clearing and settlement fees, and any other remuneration paid to third parties.
• Speed ▴ The velocity of execution, which can be critical in fast-moving markets.
• Likelihood of Execution and Settlement ▴ The probability that the trade will be successfully executed and settled, a vital consideration for illiquid or large-in-scale orders.
• Size and Nature of the Order ▴ The specific characteristics of the order, which may influence the choice of execution method to minimize market impact.

For retail clients, the framework is unambiguous ▴ the best possible result is determined by “total consideration,” meaning the combination of price and costs. For professional clients, however, the firm can apply a more nuanced weighting. For a large, illiquid OTC derivative, for instance, the likelihood of execution and minimizing market impact might outweigh the marginal benefit of a slightly better price or lower explicit costs.

For professional clients, factors beyond price, such as execution likelihood and market impact, can be prioritized when trading complex OTC instruments.

The following table illustrates how a firm might strategically weigh these factors for different types of OTC products when dealing with professional clients.

Execution

Operationalizing the Fairness Check

The operational execution of MiFID II’s requirements for OTC products demands robust internal systems and procedures. The “fairness of the price” check is an ex-ante assessment that must be embedded into the pre-trade workflow. Before executing an OTC trade, firms must have a systematic process for gathering market data to construct an internal, independent valuation of the instrument.

This process often involves sophisticated pricing models that draw on various data inputs, such as interest rate curves, volatility surfaces, and credit spreads. The key is that the firm must be able to evidence and justify its pricing decisions.

This pre-trade check is then supplemented by a post-trade monitoring process. Firms must maintain detailed records and documentation to demonstrate that these checks were performed consistently. This evidence becomes crucial during internal audits and regulatory reviews.

The operational challenge lies in creating a valuation system that is both accurate for a wide range of OTC products and efficient enough to not impede the trading process. For bespoke products with no direct comparables, the firm’s methodology for estimating a fair price must be particularly well-documented and defensible.

Data, Reporting, and Demonstrating Compliance

A significant operational lift under MiFID II comes from the enhanced reporting and disclosure requirements. These are designed to bring transparency to execution practices and allow clients to better scrutinize the quality of service they receive. The two key regulatory technical standards (RTS) are:

1. RTS 27 ▴ This requires execution venues (including SIs) to publish quarterly reports on execution quality. These reports contain detailed data on price, costs, speed, and likelihood of execution for each financial instrument. Investment firms can use this data to inform their venue selection and monitoring processes.
2. RTS 28 ▴ This requires investment firms to publish an annual report detailing the top five execution venues they used for each class of financial instrument (by volume and number of orders) and a summary of the execution quality achieved. This report effectively forces firms to publicly stand by their execution strategies and outcomes.

For OTC products, compiling this data can be complex. Firms must accurately classify their OTC trades into the prescribed instrument classes and gather the necessary data to report on their execution performance. The table below outlines some of the key data points a firm would need to collect to fulfill its RTS 28 reporting obligations for OTC derivatives.

Firms must annually publish a detailed report, known as RTS 28, that discloses their top five execution venues and provides a summary of the execution quality achieved.

Ultimately, executing on the MiFID II best execution obligation for OTC products requires a cultural shift within a firm. It necessitates investment in technology for data gathering and analysis, the development of sophisticated valuation models, and the creation of a governance structure that prioritizes and continuously monitors execution quality. The obligation is to take “all sufficient steps” to secure the best result, and regulators expect firms to be able to provide a complete, evidence-backed audit trail of how those steps were taken for every client order.

Reflection

The integration of MiFID II’s principles into the OTC landscape compels a fundamental re-evaluation of a firm’s operational architecture. The framework’s requirements for data analysis, price fairness verification, and systematic monitoring are components of a larger system of institutional intelligence. Viewing these obligations not as isolated compliance hurdles but as integrated modules within a comprehensive execution framework allows a firm to move beyond simple adherence.

The true potential lies in harnessing this required transparency and analytical rigor to build a more resilient, efficient, and ultimately superior execution capability. The question for every institution becomes how to transform these regulatory mandates into a durable, strategic advantage.