How Has Mifid Ii Reshaped the Best Execution Obligations for Non-Equity Instruments?

Concept

The implementation of the Markets in Financial Instruments Directive II (MiFID II) represents a fundamental recalibration of the best execution doctrine within the European Union. For market participants accustomed to the nuances of equity trading, the directive’s expansion into the non-equity space has necessitated a profound operational and philosophical shift. The directive’s core tenet is the mandate for investment firms to take all sufficient steps to obtain the best possible result for their clients.

This principle, while conceptually straightforward, has introduced a complex set of obligations that extend far beyond the traditional focus on price. The regulation now encompasses a broader range of financial instruments, including bonds, derivatives, and other structured products, which were previously subject to less stringent oversight.

At its heart, MiFID II seeks to enhance investor protection and increase market transparency. For non-equity instruments, which are often traded over-the-counter (OTC) and characterized by lower liquidity and greater price opacity, this has proven to be a particularly formidable challenge. The directive compels firms to look beyond their established trading relationships and consider a wider array of execution venues.

This includes regulated markets (RMs), multilateral trading facilities (MTFs), and the newly introduced organized trading facilities (OTFs). The introduction of OTFs, in particular, was a direct attempt to bring more of the non-equity market onto regulated platforms, thereby improving pre-trade and post-trade transparency.

MiFID II has fundamentally redefined best execution for non-equity instruments, moving from a principle-based approach to a more prescriptive and data-driven framework.

The directive’s impact extends to the very fabric of a firm’s trading infrastructure. It necessitates the development of sophisticated data capture and analysis capabilities to monitor and evidence the quality of execution. Firms are now required to publish annual reports detailing their top five execution venues for each class of financial instrument, a measure designed to foster greater competition and provide clients with a clearer view of their brokers’ execution practices. This has, in turn, spurred the growth of a new ecosystem of technology providers and data analytics firms, all focused on helping market participants navigate the complexities of the new regulatory landscape.

The Expanded Universe of Non-Equity Instruments

MiFID II’s reach extends to a vast and diverse array of non-equity instruments, each with its own unique market structure and liquidity profile. This has created a significant challenge for firms, as a one-size-fits-all approach to best execution is no longer viable. The directive’s requirements apply to a wide range of asset classes, including:

• Fixed Income ▴ This includes government and corporate bonds, which have traditionally been traded OTC. The introduction of pre-trade and post-trade transparency requirements has been a major change for this market.
• Derivatives ▴ Both exchange-traded and OTC derivatives fall under the purview of MiFID II. This includes a wide range of instruments, from simple interest rate swaps to complex exotic options.
• Structured Finance Products ▴ These are complex instruments that are often tailored to the specific needs of a client. The application of best execution principles to these products is particularly challenging due to their bespoke nature and lack of a liquid secondary market.
• Emission Allowances ▴ The inclusion of emission allowances as a financial instrument under MiFID II reflects the growing importance of carbon markets.

The diverse nature of these instruments means that firms must develop a nuanced and instrument-specific approach to best execution. The relative importance of the various execution factors will vary depending on the characteristics of the instrument and the client’s objectives. For a highly liquid government bond, for example, price may be the most important factor. For a complex, illiquid derivative, however, the likelihood of execution and settlement may be of greater concern.

Strategy

The strategic implications of MiFID II’s best execution obligations for non-equity instruments are far-reaching. The directive has compelled firms to move beyond a passive, compliance-oriented mindset and adopt a more proactive and data-driven approach to execution. This has required a fundamental rethinking of trading workflows, technology infrastructure, and client relationships.

The transition from the “all reasonable steps” standard of MiFID I to the “all sufficient steps” standard of MiFID II is at the heart of this strategic shift. This seemingly subtle change in wording has had a profound impact, as it requires firms to be able to demonstrate, with concrete evidence, that they have taken a comprehensive and systematic approach to achieving the best possible outcome for their clients.

A key element of this strategic response has been the development of more sophisticated order execution policies. These policies must now be far more detailed and granular than in the past, setting out a clear and transparent framework for how the firm will handle client orders across different asset classes and execution venues. The policy must also explain the relative importance of the various execution factors and how they will be weighed in different scenarios. This has required firms to invest heavily in market data and analytics, as they need to be able to justify their execution decisions with reference to a wide range of quantitative and qualitative factors.

The shift to “all sufficient steps” under MiFID II has transformed best execution from a matter of policy to a matter of proof.

The directive’s emphasis on transparency has also had a significant impact on the strategic landscape. The requirement to publish annual reports on the top five execution venues has created a new level of accountability and has given clients a powerful tool for assessing the performance of their brokers. This has, in turn, intensified competition among execution venues and has led to a greater focus on execution quality as a key differentiator. Firms that are able to demonstrate a superior execution capability are better placed to attract and retain clients in this more transparent and competitive environment.

The Four-Fold Test and Client Classification

A critical aspect of MiFID II’s best execution framework is the “four-fold cumulative test,” which firms must apply when seeking to classify a client as a professional. This test is designed to ensure that only those clients with the requisite expertise, experience, and knowledge are treated as professionals, and it has significant implications for the application of best execution. The four criteria of the test are:

1. The client’s trading frequency and volume.
2. The size of the client’s financial instrument portfolio.
3. The client’s professional experience in the relevant sector.
4. The client’s ability to understand the risks involved in the transactions or services envisaged.

The proper classification of clients is a critical first step in the best execution process, as the level of protection afforded to retail clients is significantly higher than that afforded to professional clients. For retail clients, the total consideration, representing the price of the financial instrument and the costs related to execution, is the primary factor in determining the best possible result. For professional clients, however, firms are able to exercise more discretion and may give greater weight to other execution factors, such as speed or likelihood of execution.

The Rise of New Trading Venues

MiFID II has reshaped the market structure for non-equity instruments, in part through the introduction of new types of trading venues. These new venues have provided firms with a wider range of execution options, but they have also added to the complexity of the best execution process. The main types of trading venues for non-equity instruments under MiFID II are:

• Regulated Markets (RMs) ▴ These are traditional exchanges, such as the London Stock Exchange or Euronext.
• Multilateral Trading Facilities (MTFs) ▴ These are more flexible trading venues that are operated by an investment firm or a market operator.
• Organised Trading Facilities (OTFs) ▴ This is a new category of trading venue that was introduced by MiFID II. OTFs are designed to capture more of the OTC trade flow in non-equity instruments and are subject to a greater degree of regulatory oversight than traditional OTC trading.
• Systematic Internalisers (SIs) ▴ An SI is an investment firm that, on an organised, frequent, systematic, and substantial basis, deals on its own account when executing client orders outside of a regulated market, MTF, or OTF. The SI regime has been extended to non-equity instruments under MiFID II, and SIs are now a significant source of liquidity in many non-equity markets.

The proliferation of trading venues has made the best execution process more complex, as firms must now be able to connect to and assess the quality of execution across a wider range of platforms. This has led to a greater demand for smart order routing (SOR) technology, which can help firms to automatically route orders to the venue that is most likely to provide the best possible result.

Execution

The execution of a best execution strategy for non-equity instruments under MiFID II is a complex and data-intensive undertaking. It requires a robust governance framework, a sophisticated technology infrastructure, and a deep understanding of the intricacies of the various non-equity markets. The directive’s requirements have forced firms to move away from a qualitative, relationship-based approach to execution and towards a more quantitative, evidence-based framework. This has been a particularly significant challenge in the non-equity space, where data has traditionally been more fragmented and less readily available than in the equity markets.

A cornerstone of the execution process is the systematic monitoring of execution quality. Firms are required to put in place arrangements to monitor the effectiveness of their order execution policies and to identify and, where appropriate, correct any deficiencies. This involves the regular collection and analysis of a wide range of data, including execution prices, costs, speed, and likelihood of execution. This data must then be used to assess whether the firm is consistently delivering the best possible result for its clients and to make any necessary adjustments to its execution arrangements.

In the world of MiFID II, data is the ultimate arbiter of best execution.

The public disclosure requirements of MiFID II have added another layer of complexity to the execution process. Firms are now required to publish an annual report, known as the RTS 28 report, which provides a detailed breakdown of their top five execution venues for each class of financial instrument. This report must also include a summary of the analysis and conclusions that the firm has drawn from its detailed monitoring of the quality of execution obtained on those venues. The preparation of these reports is a significant undertaking, and it requires a high degree of data accuracy and analytical rigor.

The Practical Challenges of Non-Equity Best Execution

The application of best execution principles to non-equity instruments presents a number of practical challenges. These challenges stem from the inherent characteristics of many non-equity markets, which are often less liquid, more fragmented, and more opaque than their equity counterparts. Some of the key challenges include:

• Data Scarcity ▴ In many non-equity markets, particularly those for more esoteric OTC derivatives, there is a lack of reliable and comprehensive pre-trade and post-trade data. This can make it difficult for firms to benchmark the quality of their execution and to demonstrate that they have achieved the best possible result.
• Liquidity Fragmentation ▴ Liquidity in non-equity markets is often fragmented across a wide range of different venues and counterparties. This can make it difficult for firms to access all available sources of liquidity and to ensure that they are getting the best possible price for their clients.
• Instrument Complexity ▴ Many non-equity instruments are complex and bespoke, which can make it difficult to compare prices and to assess the quality of execution. This is particularly true for structured products and exotic derivatives.

To overcome these challenges, firms have had to invest in new technologies and data sources. This includes the use of consolidated tape providers, which aggregate trade data from a wide range of different venues, and the development of sophisticated pricing models for more complex instruments. Firms have also had to place a greater emphasis on the qualitative aspects of execution, such as the creditworthiness of counterparties and the likelihood of settlement.

A Comparative Look at Execution Factors

The relative importance of the different execution factors will vary depending on the specific characteristics of the non-equity instrument being traded. The following table provides a high-level overview of how the weighting of these factors might differ across a range of different non-equity asset classes.

This table illustrates the nuanced approach that firms must take to best execution in the non-equity space. For a liquid government bond, for example, the primary focus will be on achieving the best possible price and minimizing costs. For an illiquid corporate bond, however, the likelihood of being able to execute the trade at all may be a more important consideration.

The Role of Transaction Cost Analysis

Transaction Cost Analysis (TCA) has long been a staple of the equity markets, but it is now becoming increasingly important in the non-equity space as well. TCA provides a framework for measuring the various costs associated with a trade, including both explicit costs (such as commissions and fees) and implicit costs (such as market impact and opportunity cost). By using TCA, firms can gain a more granular understanding of their execution performance and can identify areas for improvement.

The application of TCA to non-equity instruments is not without its challenges. The lack of a centralized tape and the fragmented nature of liquidity can make it difficult to establish a reliable benchmark against which to measure execution costs. However, as the availability of data in the non-equity markets continues to improve, TCA is likely to become an increasingly important tool for firms seeking to demonstrate their compliance with MiFID II’s best execution obligations.

Reflection

The implementation of MiFID II has been a watershed moment for the non-equity markets. It has brought a new level of transparency and accountability to a part of the financial system that has long been characterized by its opacity. While the transition has not been without its challenges, the directive has ultimately served to strengthen investor protection and to promote a more level playing field.

The journey towards a fully transparent and efficient non-equity market is far from over, but MiFID II has laid a solid foundation for future progress. As technology continues to evolve and as the availability of data continues to improve, the principles of best execution will become ever more deeply embedded in the fabric of the non-equity markets, to the ultimate benefit of all market participants.