Concept
The Markets in Financial Instruments Directive II (MiFID II) establishes a definition of best execution for Request for Quote (RFQ) trades that moves decisively beyond the simple metric of price. The regulation mandates that investment firms take all sufficient steps to obtain the best possible overall result for their clients. This obligation is a holistic one, encompassing a range of execution factors that must be weighed and documented.
For the bilateral and often opaque nature of RFQ-based liquidity, this represents a significant operational and philosophical shift. The framework compels firms to construct and evidence a repeatable, data-driven process that justifies their execution decisions, transforming best execution from a passive assumption into an active, demonstrable discipline.
The core of the mandate lies in its application to the specific context of the trade. MiFID II recognizes that for many instruments sourced via RFQ ▴ particularly complex derivatives or illiquid bonds ▴ the headline price is only one component of a successful outcome. The directive requires firms to consider a broader set of qualitative and quantitative factors.
These include direct and indirect costs, speed of execution, likelihood of execution and settlement, and the size and nature of the order. Consequently, a firm’s obligation is to build an execution architecture that can systematically capture, analyze, and act upon these variables in a manner that is consistent with the client’s objectives and the characteristics of the specific financial instrument.
MiFID II redefines best execution for RFQ trades as a comprehensive, evidence-based process for achieving the best overall client outcome, not just the best price.
The Principle of Sufficient Steps
A pivotal change introduced by MiFID II was the move from requiring “all reasonable steps” to “all sufficient steps.” This semantic evolution imposes a higher, more quantifiable standard of care. It requires firms to do more than just try; they must design and implement policies and procedures that are demonstrably adequate for achieving and verifying the best possible result on a consistent basis. For RFQ trades, this means a firm cannot simply solicit a quote from a single counterparty and consider its duty fulfilled. It must have a system for selecting appropriate counterparties, a methodology for evaluating the quality of the quotes received against prevailing market conditions, and a post-trade process to analyze the effectiveness of its decisions.
Legitimate Reliance in RFQ Trading
A crucial aspect for principal trading, which is common in RFQ workflows, is the concept of “legitimate reliance.” Best execution rules apply when a client has a legitimate expectation that the firm will protect their interests in the transaction. The European Commission established a four-fold test to determine if this reliance exists, considering who initiated the transaction, common market practices, the relative price transparency of the instrument, and how the firm presents its services. In many RFQ scenarios, especially those involving less sophisticated clients or highly opaque products, this test is met. As a result, the firm, even when acting as a principal, carries the full weight of the best execution obligation and must subordinate its own commercial interests to the client’s right to the best possible outcome.
Strategy
A compliant strategy for MiFID II best execution in RFQ trades is built upon a dual foundation ▴ a meticulously defined Order Execution Policy and a robust framework for analyzing the prescribed execution factors. The strategy is one of proactive design, where the firm architects a system that anticipates regulatory scrutiny and is geared toward delivering superior, evidence-based client outcomes. This involves moving beyond a check-the-box mentality to a dynamic process of pre-trade analysis, intelligent counterparty selection, and rigorous post-trade review.
The firm’s Order Execution Policy is the central strategic document. It must clearly articulate, for each class of financial instrument, how the firm will satisfy its best execution duty. For instruments typically traded via RFQ, this policy must detail the process of soliciting quotes, the universe of potential execution venues (including other liquidity providers), and the specific factors that will guide the choice of counterparty. This policy is a public commitment to a specific methodology, and regulators expect firms to adhere to it consistently and review its effectiveness at least annually.
How Should a Firm Weigh Execution Factors for RFQs?
The strategic challenge in RFQ trading is determining the relative importance of the various execution factors. MiFID II provides a list, but the weighting is contextual and must be justified. For a professional client trading a large, illiquid OTC derivative, the likelihood of execution and minimizing market impact may far outweigh the raw price or the speed of the fill.
Conversely, for a more standardized instrument, total consideration (price plus costs) remains the dominant factor. A successful strategy involves creating a decision-making matrix, often embedded within an Order Management System (OMS), that guides traders on how to prioritize these factors based on client classification, order characteristics, and prevailing market conditions.
The following table illustrates a strategic approach to weighting these factors for two distinct scenarios.
| Execution Factor | Scenario A ▴ Liquid Corporate Bond RFQ | Scenario B ▴ Complex, Illiquid Structured Product RFQ |
|---|---|---|
| Price |
Very High Importance. The primary driver, evaluated against comparable market data and competing quotes. |
High Importance. Evaluated in the context of model pricing and the cost of hedging the position. |
| Costs |
High Importance. Total consideration is key. Explicit fees and settlement costs are critical. |
Medium Importance. Implicit costs, such as the cost of delay or potential hedging slippage, are more significant than minor explicit fees. |
| Speed |
Medium Importance. Execution should be timely, but a marginal delay to secure a better price is acceptable. |
Low Importance. Rushing the trade could lead to significant price degradation. A careful, measured approach is superior. |
| Likelihood of Execution |
High Importance. The quote must be firm and settlement certain. |
Very High Importance. For illiquid instruments, securing a firm commitment from a creditworthy counterparty is paramount. |
| Size & Nature |
Medium Importance. The size may affect which counterparties can handle the trade without market impact. |
Very High Importance. The complexity and size dictate the small number of counterparties capable of pricing and managing the risk. |
Counterparty and Venue Selection
A core strategic element is the systematic management of liquidity providers. A firm must avoid relying on a static or limited set of counterparties. The strategy should involve:
- Initial Due Diligence ▴ Onboarding liquidity providers based on their financial stability, specialization, and historical performance.
- Dynamic Ranking ▴ Continuously monitoring LPs based on metrics like quote response times, fill rates, rejection reasons, and price competitiveness. This data-driven approach allows the firm to direct RFQs to the counterparties most likely to provide the best outcome for a specific type of order.
- Regular Review ▴ Periodically assessing the entire universe of execution venues to ensure the firm’s execution policy remains effective and reflects the current market structure.
This systematic approach provides a defensible audit trail, demonstrating that the choice of execution venue was the result of a deliberate and analytical process designed to benefit the client.
Execution
The execution of a MiFID II-compliant best execution framework for RFQ trades is a matter of operationalizing strategy through technology, process, and data analysis. It requires building a system that not only facilitates the trade but also generates a comprehensive audit trail to prove that all sufficient steps were taken. This system must integrate pre-trade intelligence, the execution workflow itself, and post-trade analytics into a single, coherent loop.
Executing a compliant RFQ trade under MiFID II demands a system architecture that captures every decision point, from counterparty selection to post-trade analysis.
The Operational Playbook for a Compliant RFQ
Executing a single RFQ trade in compliance with MiFID II involves a clear, multi-stage process. Each step must be recorded and auditable, forming a chain of evidence that supports the final execution decision.
- Order Receipt and Characterization ▴ The process begins when the client order is received. The system must immediately classify the order based on instrument type, size, client category (retail/professional), and any specific client instructions. This initial characterization determines the applicable execution factor weightings from the firm’s policy.
- Pre-Trade Analysis and Venue Selection ▴ Before sending any RFQs, the trader must consult pre-trade data. This includes assessing the prevailing market conditions, checking available price data from consolidated tapes or data vendors, and reviewing the historical performance of potential counterparties for this specific instrument class. The system should suggest a list of LPs to query based on this analysis.
- RFQ Dissemination and Quote Management ▴ The RFQ is sent, either manually or automatically, to the selected counterparties. The platform must capture every quote received, including the price, time of receipt, and any conditions attached. It is vital to record quotes that were not hit, as this provides a clear view of the available liquidity at the moment of execution.
- Execution Decision and Justification ▴ The trader executes the trade with the chosen counterparty. The system must require the trader to log a justification for the decision, especially if the chosen quote was not the best price. The justification would reference the pre-defined execution factors (e.g. “Chose LP ‘B’ despite slightly worse price due to higher certainty of settlement for this size,”).
- Post-Trade Confirmation and Reporting ▴ The client receives prompt confirmation of the execution. Simultaneously, all data related to the trade ▴ including all quotes received, timestamps, and the execution justification ▴ is written to a secure log for compliance and Transaction Cost Analysis (TCA).
Quantitative Modeling and Data Analysis
Post-trade analysis is where a firm proves the quality of its execution. TCA for RFQ trades differs from that of exchange-traded instruments. It focuses on the quality of the solicited quotes relative to a calculated fair value benchmark and the performance of the selected liquidity provider. The table below presents a simplified TCA report for a hypothetical RFQ trade, demonstrating the key metrics used to evidence best execution.
| Metric | Value | Description and Justification |
|---|---|---|
| Trade ID |
789-RFQ-456 |
Unique identifier for the client order. |
| Instrument |
XYZ Corp 7.5% 2035 Bond |
Identifies the illiquid corporate bond being traded. |
| Fair Value Benchmark (Pre-Trade) |
101.50 |
Calculated price based on a composite of data vendor prices and internal models before the RFQ was sent. |
| Best Quoted Price Received |
101.55 |
The most competitive price received from the five counterparties queried. |
| Executed Price |
101.55 |
The final price at which the trade was executed with Liquidity Provider C. |
| Price Improvement vs. Benchmark |
+5 bps |
Demonstrates that the RFQ process achieved a better price than the pre-trade fair value estimate. |
| Number of LPs Queried |
5 |
Shows that a sufficient number of counterparties were included to ensure competitive tension. |
| LP Rejection Rate (for this LP) |
2% |
Historical data showing the chosen LP has a very high fill ratio, supporting the ‘Likelihood of Execution’ factor. |
| Execution Justification Code |
P+L (Best Price and High Likelihood) |
System code indicating the trade was done at the best available quoted price with a highly reliable counterparty. |
What Is the Required Technological Architecture?
A compliant execution system is built on a foundation of integrated technology. At its heart is an Execution Management System (EMS) or Order Management System (OMS) that is specifically configured for RFQ workflows. This system must connect to market data sources to provide pre-trade benchmarks. It needs to have connectivity to multiple liquidity providers through APIs or dedicated platforms.
Critically, the system must function as a database of record, capturing every timestamp, quote, and decision. This data repository is the source for the firm’s quarterly RTS 27 (for execution venues) and annual RTS 28 (for investment firms) reports, which require the public disclosure of execution quality data. Without this integrated and robust technological architecture, providing the evidence required by MiFID II becomes a near-impossible manual task.
References
- European Securities and Markets Authority. “MiFID II Best Execution Q&As.” ESMA70-872942901-38, 2017.
- Financial Conduct Authority. “Markets in Financial Instruments Directive II Implementation ▴ Policy Statement II.” PS17/14, 2017.
- Kirby, Anthony. “Market opinion ▴ Best execution MiFID II.” Global Trading, 2015.
- Hogan Lovells. “Achieving best execution under MiFID II.” 2017.
- Tradeweb. “Best Execution Under MiFID II and the Role of Transaction Cost Analysis in the Fixed Income Markets.” 2017.
- Swedish Securities Markets Association. “Guide for drafting/review of Execution Policy under MiFID II.” 2017.
- Commission Delegated Regulation (EU) 2017/565. “Supplementing Directive 2014/65/EU of the European Parliament and of the Council as regards organisational requirements and operating conditions for investment firms and defined terms for the purposes of that Directive.” 2016.
Reflection
The architecture mandated by MiFID II for RFQ trades prompts a fundamental question for any investment firm ▴ is your execution framework designed as a compliance tool or as a performance engine? The regulations lay out a minimum standard for evidence and procedure. A truly superior operational framework, however, uses this mandate as a foundation for building a genuine competitive advantage.
It transforms the required data capture into a rich source of intelligence for refining counterparty selection, improving pricing models, and ultimately, delivering a measurably better result for the client. The ultimate goal is an execution system where the evidence of compliance is a natural byproduct of a relentless pursuit of the best possible outcome.
Glossary
All Sufficient Steps
Execution Factors
Best Execution
Rfq
Mifid Ii
Prevailing Market Conditions
Sufficient Steps
Legitimate Reliance
Order Execution Policy
Rfq Trades
Liquidity Providers
Execution Policy
Transaction Cost Analysis
Tca
Liquidity Provider
Rts 27
