What Are the Primary Differences in Best Execution Obligations between MiFID I and MiFID II? ▴ Question

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Concept

The transition from the Markets in Financial Instruments Directive (MiFID I) to its successor, MiFID II, represents a fundamental recalibration of the European Union’s financial markets. At its core, this evolution was driven by a need for greater transparency, investor protection, and a more resilient market structure in the wake of the 2008 financial crisis. While MiFID I laid the groundwork for a harmonized regulatory framework, MiFID II introduced a far more granular and prescriptive set of rules, particularly in the realm of best execution. The primary differences in best execution obligations between the two directives are not merely semantic; they reflect a profound shift in regulatory philosophy, moving from a principles-based approach to a more data-driven and demonstrably verifiable one.

MiFID I required firms to take “all reasonable steps” to obtain the best possible result for their clients. This was a significant step forward at the time, but the ambiguity of “reasonable” left considerable room for interpretation. MiFID II, in contrast, mandates that firms take “all sufficient steps,” a seemingly subtle change in wording that carries immense weight in practice. This shift necessitates a more rigorous and evidence-based approach to best execution.

It is no longer enough for a firm to simply have a policy in place; it must be able to demonstrate, with quantifiable data, that its execution arrangements consistently deliver the best possible outcomes for clients. This requires a deep understanding of market microstructure, a sophisticated technological infrastructure, and a commitment to continuous monitoring and improvement.

The move from “all reasonable steps” to “all sufficient steps” marks the pivotal change in best execution obligations from MiFID I to MiFID II.

The scope of financial instruments covered by best execution obligations also expanded significantly under MiFID II. While MiFID I primarily focused on equities traded on regulated markets, MiFID II extends these obligations to a much broader range of asset classes, including bonds, derivatives, and other over-the-counter (OTC) products. This expansion reflects the increasing complexity of financial markets and the need to ensure that investors are protected across all their trading activities. It also presents a significant challenge for firms, as they must now apply the same rigorous best execution standards to a diverse range of instruments, each with its own unique liquidity and trading characteristics.

Furthermore, MiFID II introduced a new layer of transparency and reporting requirements that were absent in its predecessor. The introduction of Regulatory Technical Standards (RTS) 27 and 28, for example, created a framework for the public disclosure of execution quality data. While RTS 28 has since been suspended, the underlying principle of transparency remains a cornerstone of the MiFID II regime.

This focus on data-driven disclosure has had a profound impact on the industry, forcing firms to invest in sophisticated data capture and analysis capabilities. It has also empowered investors, providing them with the information they need to assess the execution quality of their providers and make more informed decisions.

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Strategy

The strategic implications of the shift from MiFID I to MiFID II are far-reaching, extending beyond mere compliance to the very heart of a firm’s business model. The heightened best execution standards of MiFID II necessitate a more strategic and proactive approach to order handling, one that is deeply integrated with a firm’s overall investment process. This requires a fundamental rethinking of the relationship between the buy-side and the sell-side, as well as a greater emphasis on the role of technology and data analytics in achieving and demonstrating best execution.

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A More Sophisticated Approach to Venue Selection

Under MiFID I, the selection of execution venues was often a relatively straightforward process, with a focus on regulated markets and established multilateral trading facilities (MTFs). MiFID II, however, has created a more fragmented and complex execution landscape. The introduction of new trading venues, such as organized trading facilities (OTFs), and the increased focus on OTC transparency have forced firms to adopt a more sophisticated and data-driven approach to venue selection. This requires a deep understanding of the liquidity and trading characteristics of each venue, as well as the ability to analyze and compare execution quality across a range of different metrics.

A key element of this more sophisticated approach is the development of a comprehensive and dynamic best execution policy. This policy must be tailored to the specific needs of different client types and asset classes, and it must be regularly reviewed and updated to reflect changes in market conditions. It should also be supported by a robust governance framework, with clear lines of responsibility and accountability for best execution. This is a significant departure from the more static and generic policies that were common under MiFID I.

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The Rise of Transaction Cost Analysis

Transaction Cost Analysis (TCA) has emerged as a critical tool for firms seeking to comply with the best execution requirements of MiFID II. While TCA has been used in the equities market for many years, its application has expanded significantly under the new regime to include a much broader range of asset classes. This has been driven by the need for firms to be able to demonstrate, with quantifiable data, that they are consistently delivering the best possible outcomes for their clients.

Modern TCA goes far beyond the simple measurement of explicit costs, such as commissions and fees. It now encompasses a wide range of implicit costs, such as market impact, timing risk, and opportunity cost. It also involves the use of sophisticated benchmarks and analytical tools to provide a more nuanced and comprehensive assessment of execution quality. This has required firms to invest in new technologies and to develop a deeper understanding of the complex interplay between different execution factors.

The evolution of TCA under MiFID II has transformed it from a post-trade reporting tool into a pre-trade decision-making and in-trade monitoring tool.

The following table provides a comparison of TCA under MiFID I and MiFID II:

Feature	MiFID I	MiFID II
Scope	Primarily equities	All asset classes
Focus	Post-trade analysis of explicit costs	Pre-trade, in-trade, and post-trade analysis of explicit and implicit costs
Methodology	Simple benchmarks, such as VWAP	Sophisticated benchmarks, such as implementation shortfall and customized benchmarks
Data Requirements	Limited data requirements	Extensive data requirements, including high-frequency data

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The Changing Relationship between the Buy-Side and the Sell-Side

MiFID II has had a profound impact on the relationship between the buy-side and the sell-side. The unbundling of research and execution fees, for example, has forced buy-side firms to be more explicit about the value they place on different sell-side services. This has led to a more competitive and transparent market for research, and it has also forced sell-side firms to be more innovative in the services they offer.

The heightened best execution standards of MiFID II have also led to a more collaborative and data-driven relationship between the buy-side and the sell-side. Buy-side firms are now more demanding in their expectations of their sell-side partners, and they are using TCA and other analytical tools to hold them to account. This has forced sell-side firms to invest in their own best execution capabilities and to be more transparent about their execution performance.

The following list outlines some of the key changes in the buy-side/sell-side relationship under MiFID II:

Unbundling of research and execution fees ▴ This has led to a more transparent and competitive market for research.
Greater use of TCA ▴ Buy-side firms are using TCA to hold their sell-side partners to account for their execution performance.
More collaborative relationship ▴ The buy-side and sell-side are working more closely together to achieve best execution.
Increased focus on innovation ▴ Sell-side firms are being forced to be more innovative in the services they offer.

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Execution

The execution of best execution obligations under MiFID II is a complex and multifaceted process that requires a combination of sophisticated technology, robust governance, and a deep understanding of market microstructure. Firms must be able to demonstrate, on an ongoing basis, that they are taking “all sufficient steps” to obtain the best possible result for their clients. This requires a systematic and data-driven approach to order handling, one that is embedded in the firm’s culture and supported by a comprehensive set of policies and procedures.

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Developing a MiFID II-Compliant Best Execution Policy

The cornerstone of a firm’s best execution framework is its best execution policy. This document must be clear, comprehensive, and tailored to the specific needs of the firm’s clients and the asset classes it trades. It should also be a living document, one that is regularly reviewed and updated to reflect changes in market conditions and the firm’s own execution performance.

The following table outlines the key components of a MiFID II-compliant best execution policy:

Component	Description
Scope	A clear statement of the clients and financial instruments covered by the policy.
Execution Factors	A detailed explanation of the relative importance of the different execution factors (price, costs, speed, likelihood of execution, etc.) for different client types and asset classes.
Execution Venues	A list of the execution venues the firm uses for each class of financial instrument, along with a justification for their inclusion.
Order Handling Procedures	A description of the firm’s order handling procedures, including how it will deal with specific client instructions.
Monitoring and Review	A detailed explanation of how the firm will monitor the effectiveness of its best execution arrangements and how it will review its policy on a regular basis.

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Implementing a Robust Best Execution Monitoring Framework

MiFID II requires firms to monitor the effectiveness of their best execution arrangements on an ongoing basis. This requires a systematic and data-driven approach to monitoring, one that is capable of identifying and addressing any deficiencies in a timely manner. A key element of this is the use of TCA, which can provide a wealth of data on execution performance.

The following list outlines the key steps in implementing a robust best execution monitoring framework:

Data Capture ▴ The first step is to capture all the relevant data on order execution, including timestamps, prices, volumes, and venues.
Data Analysis ▴ The next step is to analyze this data using TCA and other analytical tools to identify any patterns or trends that may indicate a problem with execution quality.
Reporting ▴ The results of this analysis should be presented in a clear and concise report that can be easily understood by senior management.
Action ▴ The final step is to take action to address any deficiencies that have been identified. This may involve changing the firm’s order routing arrangements, updating its best execution policy, or providing additional training to its staff.

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The Role of Technology in Best Execution

Technology plays a critical role in enabling firms to meet their best execution obligations under MiFID II. From sophisticated order management systems (OMS) and execution management systems (EMS) to advanced TCA platforms, technology is essential for capturing, analyzing, and reporting on the vast amounts of data that are now required. It is also critical for automating many of the tasks involved in best execution, such as order routing and pre-trade analysis.

The effective use of technology is a key differentiator for firms seeking to achieve and demonstrate best execution in the MiFID II era.

The increased reliance on technology has also created new challenges for firms. They must now ensure that their systems are robust, resilient, and secure. They must also have the in-house expertise to be able to manage and interpret the vast amounts of data that these systems produce. This has led to a growing demand for data scientists and other quantitative analysts in the financial services industry.

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References

Dechert LLP. “MiFID II ▴ Best execution.” 2017.
Financial Conduct Authority. “Markets in Financial Instruments Directive II Implementation ▴ Policy Statement II.” 2017.
European Securities and Markets Authority. “Questions and Answers on MiFID II and MiFIR investor protection and intermediaries topics.” 2017.
ICMA. “MiFID II/R Fixed Income Best Execution Requirements.” 2017.
Planet Compliance. “In a nutshell ▴ Best Execution under MiFID II/MiFIR.” 2024.
SALVUS Funds. “Complying with the MiFID II Reporting Obligations of RTS 27 & RTS 28.” 2018.
Tradeweb. “Best Execution Under MiFID II and the Role of Transaction Cost Analysis in the Fixed Income Markets.” 2017.
Weil, Dan. “Trading Costs Improve as Transaction Cost Analysis Spreads.” Institutional Investor, 2018.
FlexTrade. “MiFID II ▴ The Buy-Side Transparency Challenge.” 2015.
Bayes Business School. “The Effects of MiFID II on Sell-Side Analysts, Buy-Side Analysts, and Firms.” 2019.

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Reflection

The transition from MiFID I to MiFID II has been a challenging but ultimately transformative journey for the European financial services industry. The heightened best execution standards of the new regime have forced firms to fundamentally rethink their approach to order handling, and they have also created a more transparent and competitive market for all participants. While the initial focus was on compliance, the industry is now starting to realize the broader strategic benefits of the new regime. Firms that have embraced the changes have been able to differentiate themselves on the basis of their execution quality, and they are also better placed to meet the evolving needs of their clients.

Looking ahead, the principles of transparency, investor protection, and data-driven decision-making that underpin MiFID II are likely to become even more important. The continued electronification of financial markets, the rise of new technologies such as artificial intelligence and machine learning, and the growing demand for sustainable and responsible investment products will all create new challenges and opportunities for firms seeking to achieve and demonstrate best execution. Those that are able to adapt and innovate will be the winners in this new and dynamic environment.