How Does MiFID II Specifically Define the Requirements for Best Execution?

Concept

The Markets in Financial Instruments Directive II (MiFID II) re-architected the European financial landscape, establishing a more rigorous and expansive definition of best execution. At its core, the directive mandates that investment firms take “all sufficient steps” to obtain the best possible result for their clients when executing orders. This obligation moves the concept of execution beyond a singular focus on price to a multi-dimensional assessment of quality. The framework requires firms to consider a range of execution factors, effectively treating the execution process as an engineering challenge where multiple variables must be optimized to achieve a superior outcome.

This principle is not a passive requirement; it is an active, demonstrable duty of care. Firms must design and implement a robust execution policy that is tailored to the specific needs of their clients and the nature of the financial instruments being traded. The directive compels a systematic approach, demanding that firms build a defensible process for decision-making.

This involves a continuous cycle of data collection, analysis, and review to ensure that the chosen execution strategies and venues remain optimal. The spirit of the regulation is to instill a culture of accountability, where execution quality is a quantifiable and manageable aspect of the investment service provided.

MiFID II requires a holistic evaluation of execution quality, where price is a significant component within a broader set of variables including costs, speed, and likelihood of execution.

The definition of best execution under MiFID II is therefore a comprehensive one, encompassing the entire lifecycle of an order. It begins with the firm’s execution policy, which must be clear, detailed, and agreed upon by the client. It extends to the selection of execution venues, the monitoring of execution quality, and the ability to provide evidence of compliance to both clients and regulators. This evidence-based approach is central to the directive’s intent, transforming best execution from a theoretical goal into a tangible, operational discipline.

The Execution Factors Framework

The directive specifies a set of execution factors that firms must consider when executing client orders. These factors provide the building blocks for a firm’s execution policy and serve as the criteria against which execution quality is measured. The relative importance of these factors can vary depending on the client’s classification (retail or professional), the characteristics of the order, and the nature of the financial instrument.

The primary execution factors include:

• Price The price at which the transaction is executed. For most retail clients, this is often the most important factor.
• Costs The explicit and implicit costs associated with the execution, including execution venue fees, clearing and settlement fees, and any other charges passed on to the client.
• Speed of Execution The time it takes to complete the transaction, which can be critical in fast-moving markets.
• Likelihood of Execution and Settlement The probability that the order will be executed and settled successfully. This is particularly relevant for large or illiquid orders.
• Size and Nature of the Order The specific characteristics of the order, which may influence the choice of execution venue and strategy.
• Any other consideration A catch-all category that allows firms to take into account any other relevant factors that may contribute to the best possible result for the client.

Client Categorization and Its Impact

MiFID II distinguishes between retail and professional clients, and this classification has a significant impact on how the best execution requirements are applied. For retail clients, the best possible result is determined in terms of the total consideration, which represents the price of the financial instrument and the costs related to execution. This places a strong emphasis on achieving the best price and minimizing costs.

For professional clients, the assessment of best execution can be more nuanced. While price and costs remain important, other factors such as speed, likelihood of execution, and access to liquidity may take precedence depending on the client’s specific instructions and investment strategy. This flexibility allows firms to tailor their execution approach to the sophisticated needs of institutional clients, who may prioritize factors other than total consideration to achieve their investment objectives.

Strategy

A compliant MiFID II best execution strategy is built upon a foundation of a detailed and dynamic Order Execution Policy. This policy is the central strategic document that articulates how a firm will meet its obligation to provide the best possible result for its clients. It is a living document that must be regularly reviewed and updated to reflect changes in market structure, technology, and the firm’s business model. The policy must be clear, comprehensive, and transparent, providing clients with a clear understanding of how their orders will be handled.

The development of an effective execution policy involves a number of key strategic considerations. Firms must first identify the relative importance of the execution factors for different classes of financial instruments and different types of clients. This requires a deep understanding of the products they trade and the investment objectives of their clients.

For example, for a retail client trading a liquid equity, the policy will likely prioritize price and costs. For a professional client executing a large, multi-leg options strategy, the policy may give more weight to the likelihood of execution and the management of market impact.

Venue Selection and Monitoring

A critical component of the execution strategy is the selection and monitoring of execution venues. MiFID II requires firms to have a process for selecting the venues that enable them to consistently achieve the best possible result for their clients. This process must be based on objective criteria and supported by data. Firms cannot simply rely on a static list of venues; they must actively monitor the execution quality offered by their chosen venues and be prepared to make changes if performance deteriorates.

The universe of execution venues is diverse, and each type of venue offers different advantages and disadvantages. A sophisticated execution strategy will leverage a mix of venues to optimize outcomes for different types of orders. The main categories of execution venues include:

• Regulated Markets (RMs) Traditional stock exchanges that operate under a specific regulatory framework.
• Multilateral Trading Facilities (MTFs) Systems that bring together multiple third-party buying and selling interests in financial instruments.
• Organised Trading Facilities (OTFs) A category of trading venue introduced by MiFID II for non-equity instruments, such as derivatives and bonds.
• Systematic Internalisers (SIs) Investment firms that, on an organised, frequent, systematic and substantial basis, deal on own account when executing client orders outside a regulated market, an MTF or an OTF.
• Third-country execution venues Venues located outside of the European Union.

The table below outlines some of the strategic considerations for selecting different types of execution venues.

The Role of Reporting in Strategic Review

Historically, Regulatory Technical Standards (RTS) 27 and 28 were designed to provide the data infrastructure for monitoring execution quality. RTS 27 required execution venues to publish detailed quarterly reports on execution quality, while RTS 28 required investment firms to publish annual reports on their top five execution venues and a summary of the execution quality obtained. However, recent reviews by European authorities have concluded that these reports are not widely used and do not facilitate meaningful comparisons.

As a result, the requirement for firms to produce RTS 28 reports is being removed, and regulators are no longer prioritizing supervisory action related to their publication. This development does not diminish the underlying best execution obligation. Instead, it places a greater emphasis on the firm’s internal processes for monitoring and evidencing execution quality. The strategic focus must now shift from public disclosure to internal data analysis and governance.

The phasing out of RTS 28 reporting elevates the importance of a firm’s internal Transaction Cost Analysis and data governance as the primary tools for strategic review.

Execution

The execution of a MiFID II best execution framework is a continuous, data-driven process that requires a combination of technology, expertise, and robust governance. It is in the day-to-day operations of the trading desk and the periodic reviews of the compliance function that the strategic objectives of the execution policy are translated into tangible outcomes for clients. The removal of the RTS 28 reporting obligation intensifies the need for firms to have a sophisticated internal system for monitoring and demonstrating compliance.

Transaction Cost Analysis as a Core Discipline

Transaction Cost Analysis (TCA) is the primary tool for measuring and monitoring execution quality. A comprehensive TCA program allows a firm to analyze its execution performance against a variety of benchmarks and identify opportunities for improvement. The analysis should be conducted on a regular basis and should cover all relevant asset classes and order types. The insights generated by TCA are essential for validating the firm’s execution policy and for making informed decisions about venue selection and order routing.

A robust TCA framework will typically include the following components:

1. Pre-trade analysis An assessment of the expected costs and risks of a trade before it is executed. This can help traders to select the most appropriate execution strategy.
2. Intra-trade analysis Real-time monitoring of a trade as it is being executed. This allows traders to make adjustments to the strategy in response to changing market conditions.
3. Post-trade analysis A detailed review of the execution performance after the trade is completed. This is where the firm can measure its performance against various benchmarks and identify any deviations from the expected outcome.

The table below provides an example of a simplified post-trade TCA report for a series of equity orders.

What Are the Governance and Oversight Mechanisms?

Effective execution of a best execution framework requires a strong governance structure. This typically involves the establishment of a dedicated best execution committee or function that is responsible for overseeing the firm’s compliance with its obligations. This committee should be composed of senior staff from a range of relevant departments, including trading, compliance, risk, and technology.

The responsibilities of the best execution committee should include:

• Review and approval of the Order Execution Policy Ensuring that the policy remains fit for purpose and reflects the firm’s business activities.
• Oversight of the venue selection process Reviewing the due diligence performed on new venues and the ongoing monitoring of existing venues.
• Review of TCA and other monitoring reports Analyzing the firm’s execution performance and identifying any areas of concern.
• Management of conflicts of interest Ensuring that any potential conflicts between the firm’s interests and those of its clients are identified and managed appropriately.

Robust internal governance structures are the mechanism through which a firm demonstrates its commitment to the principles of best execution.

How Does Technology Underpin Execution?

Technology plays a critical role in the execution of a MiFID II best execution framework. Order Management Systems (OMS) and Execution Management Systems (EMS) are the core platforms that enable firms to implement their execution policies and manage their order flow. These systems can be configured to automate many aspects of the execution process, from order routing and venue selection to the capture of data for TCA.

Smart Order Routers (SORs) are a key piece of technology that can help firms to achieve best execution. An SOR is an automated system that uses algorithms to determine the best place to route an order based on a set of pre-defined rules. These rules can be configured to reflect the firm’s execution policy and can take into account a wide range of factors, including price, liquidity, and speed of execution. The use of SORs can help to improve execution quality, reduce costs, and enhance the efficiency of the trading process.

Reflection

The evolution of the MiFID II best execution regime, particularly the move away from prescriptive public reporting, presents a significant operational and strategic question for every investment firm. The regulatory focus now intensifies on the internal, evidence-based systems that prove a firm’s commitment to achieving the best possible result for its clients. The core obligation has not been diluted; its proof has become a more sophisticated, internal challenge.

This shift requires a deep examination of a firm’s data architecture, analytical capabilities, and governance frameworks. Is your Transaction Cost Analysis program merely a compliance check, or is it a dynamic tool for strategic improvement? How does your execution policy adapt to the constant flux of market liquidity and technological innovation?

The absence of a public reporting mandate is an opportunity to build a truly superior internal system of intelligence, one that provides a demonstrable and defensible edge in execution quality. The ultimate measure of success lies in the system you build to validate your own performance, long before a regulator asks to see it.