How Should a Firm’s Execution Policy Adapt for Different Asset Classes under MiFID II?

Concept

A firm’s execution policy under the second Markets in Financial Instruments Directive (MiFID II) is the foundational architecture for ensuring that all sufficient steps are taken to secure the best possible result for clients. This system of protocols and procedures governs how a firm executes orders, and its adaptation for different asset classes is a complex undertaking. The directive’s best execution requirements compel a move away from a monolithic, one-size-fits-all approach to a granular, evidence-based framework that acknowledges the unique microstructure of each financial instrument. For an institutional trader, this means that the policy is a living document, a dynamic blueprint that must be calibrated to the specific liquidity profiles, trading venues, and risk characteristics of every asset class in which the firm operates.

The core of this adaptation lies in the recognition that the concept of “best execution” is not a single, static outcome. Instead, it is a process that must be tailored to the specific context of each trade. The factors that determine the best possible result for a highly liquid equity traded on a regulated market are vastly different from those for an illiquid over-the-counter (OTC) derivative.

The execution policy must, therefore, be a multi-faceted document that sets out the specific strategies and procedures for each asset class. This requires a deep understanding of the market microstructure of each instrument, including the types of trading venues available, the sources of liquidity, and the potential for market impact.

The effectiveness of a MiFID II execution policy is directly proportional to its granularity and its capacity to adapt to the unique characteristics of each asset class.

Recent guidance from the European Securities and Markets Authority (ESMA) has underscored the need for firms to move away from generic, high-level policies. ESMA’s findings suggest that many firms have failed to adequately document their choice of execution venues or to demonstrate that they have executed client orders in accordance with their policies. This has led to a push for more detailed and specific policies that clearly articulate the firm’s approach to best execution for each class of financial instrument. The updated MiFID II framework, which is expected to be transposed into national law by September 2025, will require firms to pre-select eligible execution venues for each class of financial instrument and for each category of client.

This regulatory pressure is compounded by the practical challenges of implementing a truly effective best execution framework. A 2017 survey by Liquidnet revealed that only 6% of asset managers felt they were ready to meet the MiFID II best execution standards at the time of its implementation. The survey highlighted the significant differences in approach required for different asset classes and the challenges of applying traditional transaction cost analysis (TCA) to less liquid instruments like those in fixed income. This underscores the need for a more holistic approach to best execution analysis that goes beyond simple TCA and incorporates a wider range of factors, including the pre-trade and post-trade analysis of execution quality.

Strategy

Developing a robust strategy for adapting a firm’s execution policy to different asset classes under MiFID II requires a systematic and data-driven approach. The overarching goal is to create a framework that is both compliant with the regulations and effective in achieving the best possible outcomes for clients. This involves a multi-stage process that begins with the classification of financial instruments and extends to the ongoing monitoring and review of the execution policy.

Asset Class Categorization

The first step in developing a differentiated execution policy is to categorize financial instruments into distinct classes based on their characteristics. This categorization should go beyond broad asset class labels and consider factors such as liquidity, trading venues, and typical order sizes. A common approach is to use a tiered system, similar to the fair value hierarchy in accounting standards:

• Level 1 Assets These are the most liquid instruments, such as major equities, government bonds, and exchange-traded funds (ETFs). They are typically traded on regulated markets or multilateral trading facilities (MTFs) with deep and transparent liquidity. For these assets, the execution strategy will focus on minimizing market impact and achieving competitive pricing through the use of sophisticated algorithms and smart order routers.
• Level 2 Assets This category includes less liquid instruments, such as corporate bonds, smaller-cap equities, and some derivatives. These assets may trade on a variety of venues, including organized trading facilities (OTFs) and systematic internalisers (SIs). The execution strategy for these assets will involve a more nuanced approach, balancing the use of electronic trading with high-touch execution, where traders use their expertise to source liquidity and negotiate prices.
• Level 3 Assets These are the most illiquid and complex instruments, such as structured products and some OTC derivatives. These assets are typically traded bilaterally, and there is little or no price transparency. The execution strategy for these assets will be heavily reliant on the skill and experience of the trading desk, with a focus on sourcing liquidity from a network of counterparties and using request-for-quote (RFQ) mechanisms to achieve the best possible price.

Venue and Counterparty Selection

Once the asset classes have been categorized, the next step is to identify and approve a list of execution venues and counterparties for each class. This process should be based on a thorough due diligence of each venue and counterparty, considering factors such as:

• Execution quality The ability of the venue or counterparty to consistently deliver high-quality executions, as measured by metrics such as price improvement, speed of execution, and likelihood of execution.
• Costs The explicit and implicit costs of trading on the venue or with the counterparty, including fees, commissions, and market impact.
• Liquidity The depth and quality of liquidity available on the venue or from the counterparty.
• Transparency The level of pre-trade and post-trade transparency provided by the venue or counterparty.

The firm’s execution policy should clearly document the criteria used to select execution venues and counterparties, and it should be reviewed on a regular basis to ensure that it remains appropriate. As an example, a policy for equities might prioritize venues that offer the highest likelihood of execution and the lowest market impact, while a policy for fixed income might prioritize counterparties that can provide competitive quotes for large block trades.

A well-defined venue selection strategy is the cornerstone of a MiFID II-compliant execution policy, ensuring that client orders are routed to the most appropriate trading destinations.

Execution Methodologies

The execution policy must also specify the different execution methodologies that will be used for each asset class. This will depend on the characteristics of the asset class, the size of the order, and the client’s specific instructions. Some of the most common execution methodologies include:

• Algorithmic trading The use of sophisticated computer algorithms to execute orders automatically. This is typically used for liquid assets where the goal is to minimize market impact and achieve a specific benchmark, such as the volume-weighted average price (VWAP).
• Direct market access (DMA) This allows clients to send their orders directly to the order book of an exchange or other trading venue. This is typically used by sophisticated clients who want to have more control over their executions.
• Request for quote (RFQ) This involves sending a request for a quote to a number of counterparties and then executing the trade with the counterparty that provides the best price. This is typically used for illiquid assets where there is no centralized market.
• High-touch execution This involves a trader manually working an order to find liquidity and negotiate the best possible price. This is typically used for large or complex orders where the trader’s expertise can add significant value.

How Should a Firm’s Execution Policy Differ for Equities and Bonds?

The differences in market structure between equities and bonds necessitate distinct approaches to best execution. For equities, the market is largely centralized and transparent, with a high degree of electronification. This means that the execution policy can rely heavily on quantitative analysis and algorithmic trading to achieve best execution.

In contrast, the bond market is largely decentralized and opaque, with a significant portion of trading still occurring over-the-counter. This means that the execution policy for bonds must place a greater emphasis on qualitative factors, such as the strength of the firm’s relationships with its counterparties and the skill of its traders in sourcing liquidity.

The following table illustrates some of the key differences in the execution policy for equities and bonds:

Execution

The execution of a firm’s best execution policy is where the strategic framework is translated into concrete actions. This requires a robust operational infrastructure, a skilled and experienced trading team, and a commitment to continuous improvement. The following sections provide a detailed overview of the key elements of the execution process.

Order Handling and Routing

The first step in the execution process is to handle and route client orders in a manner that is consistent with the firm’s execution policy. This requires a sophisticated order management system (OMS) that can capture all of the relevant information about an order, including the client’s identity, the financial instrument, the order size, and any specific instructions. The OMS should also be integrated with the firm’s execution management system (EMS), which is responsible for routing orders to the most appropriate execution venues.

For liquid assets, the EMS will typically use a smart order router (SOR) to automatically route orders to the venues that are most likely to provide the best execution. The SOR will take into account a variety of factors, including the price, liquidity, and speed of execution on each venue. For less liquid assets, the order may be routed to a trader who will manually work the order to find liquidity and negotiate the best possible price.

What Are the Key Components of an Execution Quality Analysis Framework?

An essential part of the execution process is the ongoing analysis of execution quality. This involves collecting and analyzing data on all of the firm’s trades to assess whether it is consistently achieving the best possible outcomes for its clients. The execution quality analysis (EQA) framework should be designed to provide a comprehensive view of the firm’s execution performance, covering all asset classes and execution methodologies. The key components of an EQA framework include:

• Data collection The firm must have a system in place to collect all of the relevant data on its trades, including the time of the order, the time of the execution, the execution price, the execution venue, and the costs of the trade.
• Benchmarking The firm must establish a set of benchmarks against which it can measure its execution performance. These benchmarks should be appropriate for the asset class and the execution methodology. For example, a common benchmark for algorithmic trades in equities is the VWAP.
• Reporting The firm must have a system in place to generate regular reports on its execution performance. These reports should be provided to senior management, the compliance department, and the firm’s clients.

The following table provides an example of a transaction cost analysis report for a portfolio of equity trades:

Monitoring and Review

The final element of the execution process is the ongoing monitoring and review of the firm’s execution policy. This is a critical process that is designed to ensure that the policy remains effective and compliant with the latest regulatory requirements. The monitoring and review process should be conducted on at least an annual basis, and it should involve a comprehensive assessment of all aspects of the firm’s execution arrangements.

Continuous monitoring and data-driven review are the mechanisms that transform a static execution policy into a dynamic and adaptive system for achieving best execution.

The monitoring and review process should include the following steps:

1. Review of the execution policy The firm should review its execution policy to ensure that it is still appropriate for the firm’s business and the markets in which it operates.
2. Review of execution venues and counterparties The firm should review its list of approved execution venues and counterparties to ensure that they are still providing high-quality executions.
3. Review of execution quality The firm should review its execution quality data to identify any areas where it can improve its performance.
4. Review of regulatory developments The firm should review any new regulatory developments to ensure that its execution policy remains compliant.

The findings of the monitoring and review process should be documented in a report that is provided to senior management. The report should identify any weaknesses in the firm’s execution arrangements and it should make recommendations for improvement. This continuous feedback loop is essential for maintaining a best execution framework that is both robust and responsive to the evolving market landscape.

Reflection

The adaptation of a firm’s execution policy for different asset classes under MiFID II is a formidable challenge, but it is also an opportunity. It is an opportunity to move beyond a compliance-driven mindset and to embrace a more strategic approach to execution that can deliver real value to clients. By developing a granular, evidence-based framework that is tailored to the specific characteristics of each asset class, firms can enhance their execution performance, reduce their operational risk, and build stronger relationships with their clients.

The journey towards a truly effective best execution framework is a continuous one, requiring a commitment to ongoing monitoring, review, and improvement. The firms that are most successful will be those that view their execution policy as a living document, a dynamic system that can adapt to the ever-changing landscape of the financial markets.