What Are the Regulatory Implications of Counterparty Curation under MiFID II Best Execution Rules?

Concept

The Unseen Hand in Execution Quality

The Markets in Financial Instruments Directive II (MiFID II) represents a significant evolution in the regulatory landscape of European financial markets. A core tenet of this regulation is the principle of best execution, a mandate that requires investment firms to secure the most favorable terms for their clients’ orders. This directive moves beyond a simplistic view of best execution as merely achieving the best price.

Instead, it introduces a more holistic framework that encompasses a range of factors, including costs, speed, and the likelihood of both execution and settlement. The transition from the “all reasonable steps” of MiFID I to the more stringent “all sufficient steps” of MiFID II underscores a fundamental shift in regulatory expectations, demanding a more rigorous and evidence-based approach from firms.

MiFID II’s best execution requirements compel investment firms to take “all sufficient steps” to secure the most favorable terms for their clients, considering a wide array of execution factors beyond just price.

At the heart of this enhanced obligation lies the practice of counterparty curation. This refers to the deliberate and ongoing process of selecting, monitoring, and managing the entities with which a firm transacts on behalf of its clients. These entities, known as execution venues, can range from traditional regulated markets to systematic internalisers and other liquidity providers.

The curation of these counterparties is not a one-time decision but a dynamic process that requires continuous assessment to ensure that the chosen venues consistently deliver the best possible outcomes for clients. This process is integral to fulfilling the best execution mandate, as the quality of a firm’s counterparties directly impacts its ability to meet its obligations to clients.

From a Broad Mandate to a Granular Framework

MiFID II extends the scope of best execution beyond equities to a wider range of financial instruments, including bonds, derivatives, and structured finance products. This expansion necessitates a more tailored approach to counterparty curation, as the optimal execution strategy can vary significantly across different asset classes. For instance, the factors that are most important for executing a large, illiquid bond order may differ from those for a small, liquid equity trade.

Consequently, firms must develop and maintain execution policies that are specific to each class of financial instrument, detailing the chosen execution venues and the rationale behind their selection. These policies must be transparent and readily available to clients, who must provide their consent to them.

The regulation also introduces a more structured approach to market organization, categorizing execution venues into distinct types, each with its own set of rules and transparency requirements. This categorization includes:

• Regulated Markets (RMs) ▴ Traditional stock exchanges that operate under a set of rules governing trading, transparency, and listing requirements.
• Multilateral Trading Facilities (MTFs) ▴ These are systems that bring together multiple third-party buying and selling interests in financial instruments, in a way that results in a contract.
• Organised Trading Facilities (OTFs) ▴ A category of trading venue that is similar to an MTF but allows for more discretion in how orders are executed.
• Systematic Internalisers (SIs) ▴ Investment firms that, on an organised, frequent, systematic and substantial basis, deal on own account when executing client orders outside a regulated market, an MTF or an OTF.

This structured market framework provides firms with a clearer understanding of the landscape of potential counterparties, but it also increases the complexity of the curation process. Firms must now assess and compare a wider range of venues, each with its own unique characteristics and implications for execution quality.

Strategy

A Multi-Faceted Approach to Counterparty Selection

A robust strategy for counterparty curation under MiFID II is not a matter of simply choosing the venues with the lowest fees. It requires a comprehensive and data-driven approach that considers all of the execution factors outlined in the regulation. These factors include not only price and costs but also speed, likelihood of execution and settlement, size and nature of the order, and any other consideration relevant to the execution of the order. The relative importance of these factors can vary depending on the specific circumstances of each trade, and firms must be able to justify their weighting of these factors in their execution policies.

A successful counterparty curation strategy under MiFID II necessitates a data-driven evaluation of execution venues against all relevant factors, not just price and cost.

The first step in developing a counterparty curation strategy is to establish a clear and well-defined execution policy. This policy should be tailored to each class of financial instrument and should outline the firm’s approach to achieving best execution. It should also identify the specific execution venues that the firm will use and explain the rationale for their selection. The policy should be reviewed on a regular basis to ensure that it remains effective and that the chosen venues continue to provide the best possible results for clients.

The Role of Data and Analytics

Data and analytics play a crucial role in the counterparty curation process. Firms must be able to collect and analyze a wide range of data to assess the performance of their execution venues and to identify any potential deficiencies in their execution arrangements. This data can include information on execution prices, costs, speed, and fill rates, as well as qualitative factors such as the reliability and robustness of a venue’s systems. While the reporting requirements under RTS 27 and RTS 28 have been largely suspended, the underlying principle of data-driven monitoring remains a key component of the best execution obligation.

The following table illustrates the key execution factors and the types of data that can be used to assess them:

By systematically collecting and analyzing this data, firms can gain a deeper understanding of the performance of their execution venues and make more informed decisions about which venues to use. This data-driven approach is essential for demonstrating compliance with the best execution requirements and for ensuring that clients consistently receive the best possible outcomes.

Execution

From Policy to Practice a Framework for Compliance

The successful execution of a counterparty curation strategy under MiFID II requires a robust operational framework that integrates policy, data, and technology. This framework should be designed to ensure that the firm’s execution arrangements are consistently delivering the best possible results for clients and that the firm is able to demonstrate its compliance with the best execution requirements to regulators and clients.

The Operational Playbook

An effective operational playbook for counterparty curation should include the following key components:

1. A clear and comprehensive execution policy ▴ This policy should be the foundation of the firm’s counterparty curation strategy. It should be tailored to each class of financial instrument and should clearly articulate the firm’s approach to achieving best execution.
2. A systematic process for selecting and onboarding new counterparties ▴ This process should include a thorough due diligence assessment of potential counterparties, including a review of their regulatory status, financial stability, and operational capabilities.
3. A robust data collection and analysis framework ▴ This framework should be designed to capture and analyze a wide range of data on the performance of the firm’s execution venues. This data should be used to monitor the effectiveness of the firm’s execution arrangements and to identify any potential areas for improvement.
4. A regular review and monitoring process ▴ The firm should regularly review its execution policy and arrangements to ensure that they remain effective and that the chosen venues continue to provide the best possible results for clients. This review process should be informed by the data collected and analyzed through the firm’s data and analytics framework.
5. A clear governance and oversight structure ▴ The firm should have a clear governance and oversight structure in place to ensure that its counterparty curation strategy is being effectively implemented and that the firm is meeting its best execution obligations.

Quantitative Modeling and Data Analysis

Quantitative modeling and data analysis are essential tools for assessing the performance of execution venues and for demonstrating compliance with the best execution requirements. The following table provides an example of how a firm might use quantitative data to compare the performance of different execution venues for a specific class of financial instrument:

This type of quantitative analysis can provide valuable insights into the relative performance of different execution venues and can help firms to make more informed decisions about which venues to use. However, it is important to remember that quantitative data is only one part of the picture. Qualitative factors, such as the reliability and robustness of a venue’s systems, should also be taken into account when assessing the performance of execution venues.

Reflection

Beyond Compliance a Strategic Imperative

The regulatory implications of counterparty curation under MiFID II are far-reaching, extending beyond a mere compliance exercise. A well-executed counterparty curation strategy is a strategic imperative that can provide a significant competitive advantage. By carefully selecting and managing their counterparties, firms can enhance their execution quality, reduce their costs, and improve their overall performance. This, in turn, can lead to improved client outcomes and a stronger, more sustainable business.

The journey towards a robust and effective counterparty curation framework is an ongoing one, requiring a commitment to continuous improvement and a willingness to embrace new technologies and data-driven approaches. The firms that are able to master this discipline will be the ones that are best positioned to thrive in the evolving regulatory landscape of European financial markets.