What Are the Key Differences in Best Execution Obligations under MiFID II for Equities and Bonds?

Concept

The Markets in Financial Instruments Directive II (MiFID II) establishes a mandate for firms to secure the optimal outcome for their clients when executing orders. This obligation, however, is not a single, rigid rule. Its application transforms significantly when shifting from the highly structured, transparent world of equities to the more fragmented and opaque domain of fixed income. For equities, the conversation is dominated by quantifiable metrics on lit exchanges.

For bonds, the process is fundamentally different, rooted in a qualitative search for liquidity across disparate pools. The core distinction lies in how “best possible result” is defined and evidenced in markets with vastly different structures, liquidity profiles, and data availability.

From “reasonable Steps” to “sufficient Steps”

MiFID II intensified the best execution standard from its predecessor, MiFID I, by elevating the requirement from taking all “reasonable steps” to taking all “sufficient steps.” This semantic shift signals a higher bar for compliance, demanding a more proactive and demonstrable effort from firms. The directive compels investment firms to establish and implement a clear order execution policy. This policy must detail the venues and factors the firm considers to consistently achieve the best results for its clients. For both equities and bonds, this means moving beyond a passive approach to execution and developing a systematic process for decision-making and review.

The Execution Factors a Differentiated Approach

MiFID II outlines several execution factors that firms must consider. These include price, costs, speed, likelihood of execution and settlement, size, and the nature of the order. The directive provides flexibility, allowing firms to weigh these factors based on the specific circumstances of the order, the client’s objectives, and the characteristics of the financial instrument. This is where the divergence between equities and bonds becomes most apparent.

For a liquid equity traded on a major exchange, price is often the paramount factor. The abundance of pre-trade and post-trade data from consolidated tapes and lit order books makes a quantitative, price-centric analysis feasible. In contrast, for an illiquid corporate bond, the “likelihood of execution” might vastly outweigh the marginal benefit of a slightly better price. The very act of finding a counterparty willing to transact in a meaningful size can be the primary determinant of a successful outcome.

Best execution under MiFID II is a qualitative assessment of process, not just a quantitative measurement of price, especially in the fixed income markets.

Market Structure the Great Divide

The operational realities of equity and bond markets dictate the practical application of best execution principles. Equity markets are largely centralized and transparent, with continuous trading on regulated markets and multilateral trading facilities (MTFs). This structure facilitates a highly quantitative approach to best execution, often employing smart order routers (SORs) to algorithmically scan multiple venues for the best available price.

Bond markets, conversely, are predominantly over-the-counter (OTC) and characterized by a lack of centralized pricing information. There are significantly more individual bond issues than equities, many of which trade infrequently. This makes a consolidated, real-time view of the market, akin to the equity market’s national best bid and offer (NBBO) in the US, an impossibility. Consequently, best execution in fixed income is less about algorithmic routing and more about a documented, defensible process of sourcing liquidity, often through request-for-quote (RFQ) protocols involving multiple dealers.

Strategy

Developing a robust best execution strategy under MiFID II requires a bespoke approach for equities and bonds, reflecting their inherent structural differences. A successful strategy moves beyond mere compliance to become a framework for optimizing client outcomes. For equities, the strategy is one of quantifiable optimization across transparent venues. For bonds, it is a strategy of qualitative diligence in an opaque market.

The Equity Execution Strategy a Quantitative Pursuit

The strategy for equity best execution is built on a foundation of data and technology. Given the high degree of pre-trade transparency and the availability of public data feeds, firms can and are expected to pursue a highly quantitative approach. The primary goal is to leverage technology to systematically scan the available liquidity and capture the best price.

• Venue Analysis ▴ A core component of the equity strategy is the continuous analysis of execution quality across various venues, including regulated markets, MTFs, and systematic internalisers. This involves monitoring factors like fill rates, execution speeds, and price improvement statistics.
• Smart Order Routing (SOR) ▴ Firms employ sophisticated SOR technology to dynamically route orders to the venue offering the best price at a given moment. The logic underpinning these routers is a key part of the best execution policy.
• Transaction Cost Analysis (TCA) ▴ Post-trade TCA is central to the equity strategy. By comparing execution prices against relevant benchmarks (e.g. Volume-Weighted Average Price – VWAP, or Arrival Price), firms can measure performance, refine their algorithms, and demonstrate to clients and regulators that their approach is effective.

The Bond Execution Strategy a Qualitative Search

The strategy for fixed income best execution is fundamentally a process of discovery and documentation. The lack of a consolidated tape and the illiquid nature of many bonds mean that a purely quantitative, price-focused strategy is often impractical and insufficient. The emphasis shifts from finding the single best price to demonstrating a thorough and fair process for sourcing liquidity.

• Counterparty Selection ▴ A critical element is the maintenance of a sufficiently broad and diverse panel of liquidity providers. The strategy must justify the selection of these counterparties and regularly review their performance.
• Request-for-Quote (RFQ) Process ▴ The RFQ protocol is the cornerstone of most fixed income execution strategies. Best practice involves sending quote requests to multiple dealers (typically a minimum of three) to create competitive tension and evidence a search for the best price. The entire process, including the quotes received and the rationale for the chosen counterparty, must be meticulously documented.
• Pre-Trade Price Discovery ▴ Before executing a trade, especially for less liquid bonds, firms must undertake a pre-trade price discovery process. This may involve using evaluated pricing services, referencing similar bonds, or analyzing historical trade data to establish a fair value range. This documented analysis forms a crucial part of the best execution evidence.

In equities, the strategy is to find the best price; in bonds, the strategy is to prove a fair process was used to discover the price.

The following table illustrates the strategic divergence in applying best execution principles to equities versus bonds:

Execution

The execution of a MiFID II-compliant best execution policy translates strategic goals into operational reality. This requires distinct workflows, data capture mechanisms, and monitoring procedures for equities and bonds. The focus for equities is on the calibration and oversight of automated systems, while for bonds, it centers on the disciplined management of a manual or semi-manual quoting process.

Operationalizing Equity Best Execution

The operational workflow for equity best execution is a continuous loop of pre-trade analysis, automated execution, and post-trade review. The firm’s execution policy must be embedded within its trading systems.

1. Policy Configuration ▴ The firm defines its best execution criteria within its Order Management System (OMS) and Execution Management System (EMS). This includes specifying the approved execution venues and the parameters governing the behavior of smart order routers and other algorithms.
2. Pre-Trade Controls ▴ Before an order is released, pre-trade TCA tools can be used to estimate potential market impact and transaction costs, helping traders select the most appropriate execution algorithm (e.g. VWAP, TWAP, Implementation Shortfall).
3. Automated Execution ▴ For most orders, the SOR automatically slices and routes the order across multiple venues according to the pre-defined logic, seeking price improvement and deep liquidity while minimizing information leakage.
4. Monitoring and Oversight ▴ The trading desk monitors execution in real-time, with the ability to intervene manually if market conditions change or if an algorithm is underperforming. All actions are time-stamped and logged for audit purposes.
5. Post-Trade Analysis ▴ Execution data is systematically fed into a TCA system. This system generates reports comparing execution performance against benchmarks, which are used for client reporting, regulatory filings (such as RTS 28 reports on top-five venues), and internal review to refine the execution strategy.

Operationalizing Bond Best Execution

The operational workflow for fixed income is more event-driven and document-intensive, reflecting the nature of OTC trading. The process is designed to create a defensible audit trail for each trade.

1. Pre-Trade Intelligence Gathering ▴ The trader begins by assessing the liquidity profile of the specific bond. This involves checking available data from trading platforms, consulting evaluated pricing sources, and potentially communicating with sales-traders to gauge market appetite. This research phase is documented.
2. RFQ Initiation ▴ The trader uses an EMS or dedicated platform to construct an RFQ, selecting a sufficient number of dealers from the approved counterparty list. The selection of dealers should be appropriate for the size and nature of the bond.
3. Quote Management and Execution ▴ As quotes are returned, they are automatically captured and displayed, allowing the trader to compare prices and sizes. The trader executes against the chosen quote. The system must record all quotes received, not just the winning one.
4. Documentation of Rationale ▴ This is a critical step. If the trader does not execute at the best price, or if fewer than the standard number of quotes were solicited, the rationale must be recorded. For example, the best-priced quote may have been for an insufficient size, or a specific counterparty may have been chosen for its higher likelihood of settlement.
5. Periodic Review ▴ On a periodic basis, the firm analyzes its execution data. This involves reviewing the competitiveness of quotes from different dealers, assessing the quality of the counterparty panel, and ensuring the documented procedures are being followed consistently.

Equity execution is a process of system oversight, while bond execution is a process of evidence creation.

The data required to evidence best execution differs substantially between the two asset classes, as detailed in the table below.

Reflection

The dual obligations for equities and bonds under MiFID II compel a re-evaluation of a firm’s entire execution philosophy. It moves the conversation from a singular focus on compliance to a deeper consideration of operational design. The systems and skills required to demonstrate best execution in the data-rich environment of equities are fundamentally different from those needed to navigate the opaque, relationship-driven world of fixed income.

A truly effective framework recognizes this divergence not as a burden, but as an accurate reflection of market reality. The ultimate objective is to construct an evidence-based process that is authentic to the asset class, ensuring that the spirit of the regulation ▴ achieving the best outcome for the client ▴ is fulfilled through a system that is both defensible and operationally sound.