How Has MiFID II Impacted the Use of RFQs in European Equity Markets?

Concept

The Regulatory Recalibration of Liquidity

Before the implementation of the Markets in Financial Instruments Directive II (MiFID II), the European equity market operated under a different liquidity paradigm. Institutional investors frequently utilized dark pools for executing large block orders, valuing the discretion and minimal market impact these venues offered. Dark pools, by their nature, lack pre-trade transparency, meaning the price and size of orders are not displayed publicly until after execution.

This characteristic was particularly advantageous for asset managers who needed to move significant positions without signaling their intentions to the broader market, which could lead to adverse price movements. The original MiFID framework, implemented in 2007, permitted this off-exchange trading through specific waivers, contributing to a steady increase in dark pool volumes, which accounted for a substantial portion of all European equity trading.

The Request for Quote (RFQ) protocol, while a long-established mechanism, occupied a different niche, primarily in markets like fixed income and derivatives where instruments are more heterogeneous and trade less frequently. In equities, its use was less industrialized compared to the more dominant lit exchanges and dark pools. The existing regulatory landscape allowed for a significant amount of trading to occur with limited transparency, which regulators eventually perceived as a potential detriment to the public price discovery process and fairness for all market participants. This perception set the stage for a fundamental overhaul, aiming to bring more trading activity into regulated and transparent environments.

MiFID II a New Framework for Transparency

The introduction of MiFID II in 2018 marked a deliberate and systemic effort to reshape European market structures. A central objective was to enhance transparency and steer trading activity towards regulated venues. To achieve this, the directive introduced several critical measures, with the Double Volume Cap (DVC) being one of the most impactful.

The DVC mechanism imposes strict limits on the amount of dark trading that can occur in a specific stock, capping it at 4% on any single trading venue and 8% across all European venues combined over a rolling 12-month period. This rule was designed to curtail the pervasive use of dark pools for smaller trades that could otherwise be executed on transparent “lit” exchanges.

MiFID II fundamentally altered market structure by imposing strict limits on dark pool trading, compelling participants to seek new liquidity channels.

Concurrently, MiFID II expanded the definition and obligations of a Systematic Internaliser (SI). An SI is an investment firm that deals on its own account by executing client orders outside of a regulated market or multilateral trading facility (MTF). Under the new rules, firms exceeding certain trading thresholds in a particular instrument are required to register as an SI for that instrument. This registration comes with specific pre-trade transparency obligations, requiring SIs to provide firm quotes to their clients upon request.

The regulation also reinforced best execution requirements, mandating that investment firms take all sufficient steps to obtain the best possible result for their clients. This created a powerful incentive for firms to develop robust, auditable execution processes, a condition that the electronic nature of RFQ platforms readily satisfies.

Strategy

Navigating the Post-Transparency Landscape

The implementation of MiFID II’s Double Volume Cap acted as a significant catalyst, compelling a strategic re-evaluation of execution methods among institutional investors. As numerous stocks breached the 8% market-wide cap, their trading in dark pools was suspended, forcing market participants to find alternative venues for liquidity. This regulatory constraint directly curbed the utility of traditional dark pools for a large swath of the market.

Consequently, a substantial volume of order flow that previously sought anonymity in dark pools needed a new destination. This created a vacuum in the execution landscape, particularly for orders that were not large enough to qualify for the Large-in-Scale (LIS) waiver, which exempts block trades from the DVC.

In response, market participants began to gravitate towards two primary alternatives ▴ Systematic Internalisers and newly adapted RFQ platforms. SIs, operated by major banks and investment firms, became central liquidity hubs. These firms could internalize client order flow, dealing on their own account and providing the necessary liquidity that was now restricted in dark pools. The RFQ protocol emerged as the natural mechanism for interacting with these SIs.

An institutional trader could send a request for a quote to a panel of SIs, receiving competitive, executable prices in a controlled, bilateral, and compliant manner. This process allowed for discreet price discovery without broadcasting trading intent to the public market, effectively replicating one of the key benefits of dark pool trading while operating within the new regulatory framework.

The Ascendance of the Systematic Internaliser and RFQ Synergy

The MiFID II framework elevated the role of Systematic Internalisers from a relatively niche designation to a cornerstone of the European market structure. For large banks and dealers, operating an SI became a strategic imperative to continue servicing client order flow that could no longer be routed to dark venues. For the buy-side, these SIs became indispensable sources of liquidity. The RFQ protocol provided the ideal technical and procedural bridge between the buy-side’s need for liquidity and the SIs’ obligation to provide quotes.

The RFQ protocol became the primary interaction layer for accessing concentrated liquidity within Systematic Internalisers, creating a new, compliant off-exchange ecosystem.

This symbiotic relationship fostered significant growth in RFQ platform usage. These platforms evolved from simple messaging tools to sophisticated electronic venues that integrated seamlessly with traders’ Order and Execution Management Systems (O/EMS). They offered an efficient workflow to solicit quotes from multiple SIs simultaneously, compare prices, and execute trades, all while generating a detailed electronic audit trail.

This audit trail became critically important for demonstrating compliance with MiFID II’s stringent best execution requirements, as it provided clear evidence of the competitive quoting process. The result was the industrialization of the RFQ process for equities, transforming it into a primary tool for accessing off-exchange liquidity.

The table below illustrates the strategic shift in execution venue selection for a typical institutional equity order before and after MiFID II’s implementation.

Adapting to a Fragmented Market

An unintended consequence of MiFID II was increased market fragmentation. Rather than consolidating liquidity onto lit exchanges as intended, the regulations dispersed it across a complex web of lit markets, SIs, and auction-based venues. In this environment, the RFQ protocol provided a crucial tool for efficiently sourcing liquidity from disparate pools. A single RFQ could query multiple SIs at once, effectively performing a search for the best price among key liquidity providers without leaking information.

This ability to aggregate fragmented liquidity in a controlled manner became a significant strategic advantage. Furthermore, the use of RFQ platforms for trading Exchange-Traded Funds (ETFs) surged, as the protocol proved highly effective for executing large ETF trades that were difficult to transact on public exchanges without significant market impact.

Execution

The Operational Mechanics of Modern Equity RFQs

The execution of an equity trade via an RFQ protocol under MiFID II is a structured, technology-driven process designed for efficiency and compliance. The workflow begins within the trader’s Execution Management System (EMS), where an order is staged. Instead of routing the order directly to a lit market or an algorithm, the trader selects an RFQ-based strategy. This initiates a connection to an RFQ platform, which acts as a hub connecting the buy-side firm to its chosen panel of liquidity providers, typically Systematic Internalisers.

The core steps of the execution protocol are as follows:

1. Counterparty Selection ▴ The trader curates a list of counterparties (SIs) to include in the inquiry. This selection is a critical part of the strategy, based on past performance, relationship, and the specific characteristics of the stock being traded.
2. Quote Solicitation ▴ The RFQ, containing the instrument identifier, size, and side (buy/sell), is sent electronically and simultaneously to the selected panel. This request is private and only visible to the solicited firms, preventing information leakage to the broader market.
3. Response Aggregation ▴ The platform aggregates the responses from the SIs in real-time. Each SI provides a firm, executable quote, which is typically valid for a short period (seconds or milliseconds).
4. Execution Decision ▴ The trader’s EMS displays the aggregated quotes, highlighting the best bid and offer. The trader can then execute against the desired quote with a single click. The electronic nature of this process ensures that the firm can systematically prove it engaged in a competitive process to achieve the best price, fulfilling a key tenet of MiFID II’s best execution mandate.
5. Post-Trade Reporting ▴ Upon execution, the reporting responsibility falls to the Systematic Internaliser. The SI is obligated to report the details of the trade to the public via an Approved Publication Arrangement (APA), ensuring post-trade transparency as required by the regulation.

Quantitative Analysis and Execution Quality

A fundamental aspect of the post-MiFID II execution process is the rigorous analysis of execution quality. The detailed audit trail generated by RFQ platforms provides rich data for Transaction Cost Analysis (TCA). Firms can systematically measure the performance of their RFQ strategies against various benchmarks.

The primary metric is often price improvement versus the European Best Bid and Offer (EBBO) at the time of the request. This allows firms to quantify the value added by using the RFQ protocol compared to simply crossing the spread on a lit exchange.

The electronic audit trail from RFQ platforms provides the granular data necessary for rigorous Transaction Cost Analysis, enabling firms to prove best execution.

The table below presents a hypothetical TCA report for a series of trades executed via an RFQ platform, demonstrating the type of analysis that is now standard practice.

This data allows firms to not only validate their execution strategy but also to refine it. By analyzing performance by counterparty, time of day, and stock characteristics, trading desks can build sophisticated counterparty selection models, further optimizing their RFQ process. This data-driven approach is a direct outcome of the regulatory push for greater accountability and transparency.

Reflection

A System Forged by Constraint

The evolution of the RFQ protocol within European equities is a compelling study in market adaptation. A regulatory mandate designed to increase on-exchange transparency inadvertently catalyzed the development of a more sophisticated and industrialized off-exchange ecosystem. The constraints imposed by the Double Volume Cap did not eliminate the institutional need for discreet execution; instead, they forced that need to be met through a different technological and procedural channel. This demonstrates the resilience of market dynamics; when one path is narrowed, liquidity and innovation will flow to another.

Considering this evolution prompts a deeper evaluation of one’s own operational framework. The critical question is how a trading system adapts not only to market volatility but also to structural and regulatory shifts. An effective execution framework is one that provides access to the full spectrum of liquidity, understands the distinct advantages of each protocol, and possesses the analytical capability to measure and validate every execution decision.

The shift towards RFQs was not merely a change in venue preference; it represented a deeper integration of technology, data analysis, and regulatory compliance into the core of the trading function. The resulting system, built on the foundation of auditable, competitive price discovery, provides a robust model for navigating the complexities of modern, fragmented markets.